ATC 14-1 (Pg. 686)

1.(Follow the cash) In a narrative format, answer the questions posed in the case.

2.What is meant by "presentation of financial statement information in common-size amounts rather than dollar amounts?" Why is this type of presentation sometimes more meaningful than use of actual dollar amounts?

3.Why is trend just as important if not more important than information that pertains to only one year?

* Each separate response must have approximately 200 words. Assignments vary widely; however, essays should be written in APA style, with in-text citations and a separate reference listing as needed. Basically, you need to cite and reference a relevant source for assignments that have an essay component. This means you are required to conduct research on your own outside the information provided in the text (i.e. an external reference). Note, some assignment requirements will require primarily calculating a specific accounting figure and require only minimum explanation. In these cases, the word count requirement will be relaxed.

edm10890_ch01_002-053.indd Page 2 6/18/10 4:22 PM user-f497 /Users/user-f497/Desktop/MHBR165 CHAPTER 1 B R O O K S L E LEARNING OBJECTIVES N T After you have mastered the material in this chapter, you will be able to: Z 1 Distinguish between managerial and financial accounting. 2 Identify the cost components of a product made by,a manufacturing company: the cost of materials, labor, Management Accounting and Corporate Governance and overhead. 3 4 5 6 7 8 Explain the effects on financial statements of product costs versus general, selling, and administrative costs. B Distinguish product costs from upstream and downstream costs. R Explain how product costing differs in service, merchandising, and manufacturing companies. I Show how just-in-time inventory can increase profitability. D G Identify the key components of corporate governance. I Identify emerging trends in accounting (Appendix A). T CHAPTER OPENING 2 Andy Grove, Senior Advisor to Executive Management of Intel Corporation, is credited with the motto \"Only the 0 paranoid survive.\" Mr. Grove describes a wide variety of concerns that make him paranoid. Specifically, he declares: 4 I worry about products getting screwed up, and I worry about products getting introduced prematurely. I 4 worry about factories not performing well, and I worry about having too many factories. I worry about hiring B the right people, and I worry about morale slacking off. And, of course, I worry about competitors. I worry about other people figuring out how to do what we do better or cheaper, and displacing us with our customers. U Do Intel's historically-based financial statements contain the information Mr. Grove needs? No. Financial accounting is not designed to satisfy all the information needs of business managers. Its scope is limited to the needs of external users such as investors and creditors. The field of accounting designed to meet the needs of internal users is called managerial accounting. 2 edm10890_ch01_002-053.indd Page 3 6/18/10 6:42 PM user-f497 /Users/user-f497/Desktop/MHBR165 The Curious Accountant In the first course of accounting, you learned how retailers, such as Sears, account for the cost of equip- B ment that lasts more than one year. Recall that the R equipment was recorded as an asset when purchased, O and then it was depreciated over its expected useful O life. The depreciation charge reduced the company's K assets and increased its expenses. This approach was S justified under the matching principle, which seeks to - L E the cost (resource) is used to generate revenue. N Is depreciation always shown as an expense on T the income statement? The answer may surprise you. Z Consider the following scenario. Schwinn manufactures , recognize costs as expenses in the same period that the bicycles that it sells to Sears. In order to produce the bicycles, Schwinn had to purchase a robotic machine B R Do you think Schwinn should account for depreciation on its manufacturing equipment the same way Sears I accounts for depreciation on its registers at the checkout counters? If not, how should Schwinn account for its D depreciation? Remember the matching principle when thinking of your answer. (Answer on page 12.) G I T that it expects can be used to produce 50,000 bicycles. 2 0 4 4 B U 3 edm10890_ch01_002-053.indd Page 4 6/18/10 3:35 PM user-f497 4 /Users/user-f497/Desktop/MHBR165 Chapter 1 DIFFERENCES BETWEEN MANAGERIAL AND FINANCIAL ACCOUNTING Users and Types of Information Financial accounting provides information used primarily by investors, creditors, and others outside a business. In contrast, managerial accounting focuses on information used by executives, managers, and employees who work inside the business. These two B user groups need different types of information. Internal users need information to plan, direct, and control business operations. The R nature of information needed is related to an employee's job level. Lower level emO ployees use nonfinancial information such as work schedules, store hours, and customer service policies. Moving up the organizational ladder, financial information becomes O increasingly important. Middle managers use a blend of financial and nonfinancial K information, while senior executives concentrate on financial data. To a lesser degree, S senior executives also use general economic data and nonfinancial operating information. For example, an executive may consider the growth rate of the economy before deciding to expand the company's workforce. L External users (investors and creditors) have greater needs for general economic information than do internal users. For example, an investor debating whether to purE chase stock versus bond securities might be more interested in government tax policy N than financial statement data. Exhibit 1.1 summarizes the information needs of different user groups. T Z Level of Aggregation , External users generally desire global information that reflects the performance of a company as a whole. For example, an investor is not so much interested in the performance of a particular Sears store as she is in the performance of Sears Roebuck Company versus B that of JC Penney Company. In contrast, internal users focus on detailed information R about specific subunits of the company. To meet the needs of the different user groups, I financial accounting data are more aggregated than managerial accounting data. D G I EXHIBIT 1.1 T Relationship Between Type of User and Type of Information Economic data Outsiders Distinguish between managerial and financial accounting. While the information needs of internal and external users overlap, the needs of managers generally differ from those of investors or creditors. Some distinguishing characteristics are discussed in the following section. Insiders LO 1 2 Investors and creditors 0 4 4 B U Financial data Nonfinancial data Senior executives Middle managers Operating employees edm10890_ch01_002-053.indd Page 5 6/18/10 3:35 PM user-f497 /Users/user-f497/Desktop/MHBR165 Management Accounting and Corporate Governance Regulation Financial accounting is designed to generate information for the general public. In an effort to protect the public interest, Congress established the Securities and Exchange Commission (SEC) and gave it authority to regulate public financial reporting practices. The SEC has delegated much of its authority for developing accounting rules to the private sector Financial Accounting Standards Board (FASB), thereby allowing the accounting profession considerable influence over financial accounting reports. The FASB supports a broad base of pronouncements and practices known as generally accepted accounting principles (GAAP). GAAP severely restricts the accounting procedures and practices permitted in published financial statements. B Beyond financial statement data, much of the information generated by manageR ment accounting systems is proprietary information not available to the public. Since this information is not distributed to the public, it need not be regulated to protect O the public interest. Management accounting is restricted only by the value-added O principle. Management accountants are free to engage in any information gathering K and reporting activity so long as the activity adds value in excess of its cost. For example, management accountants are free to provide forecasted information to S internal users. In contrast, financial accounting as prescribed by GAAP does not permit forecasting. L E While financial accounting is characterized by its objectivity, reliability, consistency, and historical nature, managerial accounting is more N concerned with relevance and timeliness. Managerial accounting uses more estimatesT fewer facts than financial and accounting. Financial accounting reports what happened yesterday; managerial Z accounting reports what is expected to happen tomorrow. , Information Characteristics Time Horizon and Reporting Frequency Financial accounting information is reported periodically, normally at the end of a B year. Management cannot wait until the end of the year to discover problems. PlanR ning, controlling, and directing require immediate attention. Managerial accounting information is delivered on a continuous basis. I Exhibit 1.2 summarizes significant differences between financial and managerial D accounting. G I PRODUCT COSTING IN MANUFACTURING T COMPANIES A major focus for managerial accountants is determining product cost.1 Managers need 2 to know the cost of their products for a variety of reasons. For example, cost-plus is pricing is a common business practice.2 Product costing 0 also used to control business operations. It is useful in answering questions such as: Are costs higher or lower than 4 expected? Who is responsible for the variances between expected and actual costs? What actions can be taken to control the variances? 4 B U A company normally incurs three types of costs when making products. Specifically, Components of Product Cost the company must pay for (1) the materials used to make the products, (2) the labor 1 This text uses the term product in a generic sense to mean both goods and services. Other pricing strategies will be introduced in subsequent chapters. 2 LO 2 Identify the cost components of a product made by a manufacturing company: the cost of materials, labor, and overhead. 5 edm10890_ch01_002-053.indd Page 6 6/18/10 3:35 PM user-f497 6 /Users/user-f497/Desktop/MHBR165 Chapter 1 EXHIBIT 1.2 Comparative Features of Managerial versus Financial Accounting Information Features Managerial Accounting Financial Accounting Users Insiders including executives, managers, and operators Information type Economic and physical data as well as financial data Local information on subunits B of the organization R No regulation, limited only by the O value-added principle Estimates that promote O relevance and enable timeliness K Outsiders including investors, creditors, government agencies, analysts, and reporters Financial data Level of aggregation Regulation Information characteristics Time horizon Reporting frequency S Past, present, and future Continuous reporting Global information on the company as a whole Regulation by SEC, FASB, and other determiners of GAAP Factual information that is characterized by objectivity, reliability, consistency, and accuracy Past only, historically based Delayed with emphasis on annual reports L E N expended by the employees who transform the materials into products, and (3) the overhead (other resources suchT utilities and equipment consumed in the process of as making the products). If the company stores its products, the costs of the materials, Z labor, and overhead used in making the products are maintained in an inventory account until the products are ,sold. For a detailed explanation of how product costs flow through the financial statements, refer to the following example of Tabor Manufacturing Company. B R Tabor Manufacturing Company Tabor Manufacturing Company makes wooden tables. The company spent $1,000 cash I to build four tables: $390 for materials, $470 for a carpenter's labor, and $140 for D tools used in making the tables. How much is Tabor's expense? The answer is zero. The G $1,000 cash has been converted into products (four tables). The cash payments for materials, labor, and tools (overhead) were asset exchange transactions. One asset (cash) I decreased while another asset (tables) increased. Tabor will not recognize any expense T until the tables are sold; in the meantime, the cost of the tables is held in an asset account called Finished Goods Inventory. Exhibit 1.3 illustrates how cash is transformed into inventory. 2 Average Cost per Unit 0 4 How much did each table made by Tabor cost? The actual cost of each of the four tables likely differs. The carpenter probably spent a little more time on some of the tables 4 than others. Material and tool usage probably varied from table to table. Determining B the exact cost of each table is virtually impossible. Minute details such as a second of labor time cannot be effectively U measured. Even if Tabor could determine the exact cost of each table, the information would be of little use. Minor differences in the cost per table would make no difference in pricing or other decisions management needs to make. Accountants therefore normally calculate cost per unit as an average. In the case of Tabor Manufacturing, the average cost per table is $250 ($1,000 4 4 units). Unless otherwise stated, assume cost per unit means average cost per unit. edm10890_ch01_002-053.indd Page 7 6/18/10 3:35 PM user-f497 /Users/user-f497/Desktop/MHBR165 Management Accounting and Corporate Governance EXHIBIT 1.3 Transforming the Asset Cash Into the Asset Finished Goods Inventory Financial assets Manufacturing process Physical assets $390 materials Converted Converted B $470 labor R O O $1,000 of finished goods K $140 overhead S L E CHECK YOURSELF 1.1 N All boxes of General Mills' Total Raisin Bran cereal are priced at exactly the same amount in your local grocery store. Does this mean that the actual cost ofT making each box of cereal was exactly the same? Z , Answer No, making each box would not cost exactly the same amount. For example, some $1,000 of cash boxes contain slightly more or less cereal than other boxes. Accordingly, some boxes cost slightly more or less to make than others do. General Mills uses average cost rather than B actual cost to develop its pricing strategy. R I D Costs Can Be Assets or Expenses G It might seem odd that wages paid to production workers are recorded as inventory instead of being expensed. Remember, however, that expenses are assets used in the I process of earning revenue. The cash paid to production workers is not used to produce T revenue. Instead, the cash is used to produce inventory. Revenue will be earned when the inventory is used (sold). So long as the inventory remains on hand, all product costs (materials, labor, and overhead) remain in an inventory account. When a table is sold, the average cost of the table is 2 transferred from the Inventory account to the Cost of Goods Sold (expense) account.0 some tables remain unsold If at the end of the accounting period, part of the product costs is reported as an asset 4 (inventory) on the balance sheet while the other part is reported as an expense (cost of goods sold) on the income statement. 4 Costs that are not classified as product costs are normally expensed in the period B in which they are incurred. These costs include general operating costs, selling and administrative costs, interest costs, and the cost of income taxes. U To illustrate, return to the Tabor Manufacturing example. Recall that Tabor made four tables at an average cost per unit of $250. Assume Tabor pays an employee who sells three of the tables a $200 sales commission. The sales commission is expensed immediately. The total product cost for the three tables (3 tables 3 $250 each 5 $750) is expensed on the income statement as cost of goods sold. The portion of the total 7 edm10890_ch01_002-053.indd Page 8 6/18/10 3:35 PM user-f497 8 /Users/user-f497/Desktop/MHBR165 Chapter 1 EXHIBIT 1.4 Cost Classification for Tabor Manufacturing Company Cost category Balance sheet $1,000 Cost of finished goods $1,000 Product cost Materials Labor Overhead (tools) Income statement $750 (Products sold) Cost of goods sold B $250 R (Products not sold) Ending inventory O O K $200 $200 General, selling, Selling and S and administrative administrative expense costs L E product cost remaining in inventory is $250 (1 table 3 $250). Exhibit 1.4 shows the N relationship between the costs incurred and the expenses recognized for Tabor ManuT facturing Company. Z Effect of Product Costs, on Financial Statements LO 3 Explain the effects on financial statements of product costs versus general, selling, and administrative costs. We illustrate accounting for product costs in manufacturing companies with Patillo Manufacturing Company, a producer of ceramic pottery. Patillo, started on January 1, 2013, experienced the following accounting events during its first year of operations. 3 B Assume that all transactions except 6, 8, and 10 are cash transactions. R 1. Acquired $15,000 cash by issuing common stock. I 2. Paid $2,000 for materials that were used to make products. All products started were completed during the D period. G 3. Paid $1,200 for salaries of selling and administrative employees. 4. Paid $3,000 for wages of production workers. I 5. Paid $2,800 for furniture used in selling and administrative offices. T 6. Recognized depreciation on the office furniture purchased in Event 5. The furniture was acquired on January 1, had a $400 estimated salvage value, and a four-year useful life. The annual depreciation charge is $600 [($2,800 2 $400) 4 4]. 2 7. Paid $4,500 for manufacturing equipment. 0 8. Recognized depreciation on the equipment purchased in Event 7. The equipment 4 was acquired on January 1, had a $1,500 estimated salvage value, and a three-year 4 useful life. The annual depreciation charge is $1,000 [($4,500 2 $1,500) 4 3]. 9. Sold inventory to customers for $7,500 cash. B 10. The inventory sold in Event 9 cost $4,000 to make. U 3 This illustration assumes that all inventory started during the period was completed during the period. Patillo therefore uses only one inventory account, Finished Goods Inventory. Many manufacturing companies normally have three categories of inventory on hand at the end of an accounting period: Raw Materials Inventory, Work in Process Inventory (inventory of partially completed units), and Finished Goods Inventory. Chapter 11 discusses these inventories in greater detail. edm10890_ch01_002-053.indd Page 9 7/9/10 3:39 PM user-f497 /Volumes/105/PHS00142/work/indd Management Accounting and Corporate Governance 9 EXHIBIT 1.5 Effect of Product versus Selling and Administrative Costs on Financial Statements Assets Event No. Cash 1 15,000 2 (2,000) 3 (1,200) 4 (3,000) Equity Manuf. Equip.* 5 Com. Stk. 5 Ret. Earn. 15,000 2 Exp. 5 Net Inc. B R 5 (2,800) 1 2,800 O 5 6 (600) (600) O 7 (4,500) 1 4,500 8 1,000 1 (1,000) K 9 7,500 7,500 7,500 S 5 10 (4,000) 5 (4,000) Totals 9,000 1 2,000 1 2,200 1 3,500 5 15,000 1 1,700 7,500 L *Negative amounts in these columns represent accumulated depreciation. E N The effects of these transactions on the balance sheet and income statement are shown in Exhibit 1.5. Study each row in this exhibit, T paying particular attention to how similar costs such as salaries for selling and administrative personnel and wages Z for production workers have radically different effects on the financial statements. The example illustrates the three elements of product costs, materials (Event 2), labor , 2 1,200 5 (1,200) 2 600 5 (600) 5 7,500 1 Inventory Office Furn.* Rev. 1 1 1 2,000 5 1 1 (1,200) 3,000 (Event 4), and overhead (Event 8). These events are discussed in more detail below. Materials Costs (Event 2) B Materials used to make products are usually called raw materials. The cost of raw maR terials is first recorded in an asset account (Inventory). The cost is then transferred from the Inventory account to the Cost of Goods SoldI account at the time the goods are sold. Remember that materials cost is only one component of total manufacturing D costs. When inventory is sold, the combined cost of materials, labor, and overhead G is expensed as cost of goods sold. The costs of materials that can be easily and conveniently traced to products are called direct raw materials costs. I Labor Costs (Event 4) T The salaries paid to selling and administrative employees (Event 3) and the wages paid to production workers (Event 4) are accounted for differently. Salaries paid to selling 2 and administrative employees are expensed immediately, but the cost of production wages is added to inventory. Production wages are expensed as part of cost of goods sold 0 at the time the inventory is sold. Labor costs that can be easily and conveniently traced 4 to products are called direct labor costs. The cost flow of wages for production employees versus salaries for selling and administrative personnel is4 shown in Exhibit 1.6. B Overhead Costs (Event 8) Although depreciation cost totaled $1,600 ($600 on office furniture and $1,000 on manU ufacturing equipment), only the $600 of depreciation on the office furniture is expensed directly on the income statement. The depreciation on the manufacturing equipment is split between the income statement (cost of goods sold) and the balance sheet (inventory). The depreciation cost flow for the manufacturing equipment versus the office furniture is shown in Exhibit 1.7. 2 4,000 5 (4,000) 2 5,800 5 1,700 edm10890_ch01_002-053.indd Page 10 6/18/10 3:35 PM user-f497 10 /Users/user-f497/Desktop/MHBR165 Chapter 1 EXHIBIT 1.6 Flow of Labor Costs Labor costs Balance sheet Inventory Production wages Selling and administrative salaries EXHIBIT 1.7 Flow of Depreciation Costs Overhead cost Depreciation on manufacturing equipment Depreciation on office furniture Total Product Cost. shown in Exhibit 1.8. B R O O K S L E N T Z , Income statement Cost of goods sold Salaries expense Balance sheet Inventory B R I D G I A summary of T Income statement Cost of goods sold Depreciation expense Patillo Manufacturing's total product cost is Financial Statements 2 The income statement and balance sheet for Patillo Manufacturing are displayed in 0 Exhibit 1.9. 4 Product Costs. The $4,000 cost of goods sold reported on the income statement in4 cludes a portion of the materials, labor, and overhead costs incurred by Patillo during the year. Similarly, the $2,000 of finished goods inventory on the balance sheet includes B materials, labor, and overhead costs. These product costs will be recognized as expense U in the next accounting period when the goods are sold. Initially classifying a cost as a product cost delays, but does not eliminate, its recognition as an expense. All product costs are ultimately recognized as expense (cost of goods sold). Selling, General, and Administrative Costs. Selling, general, and administrative costs (SG&A) are normally expensed in the period in which they are incurred. Because of this recognition pattern, nonproduct expenses are sometimes called period costs. In Patillo's edm10890_ch01_002-053.indd Page 11 7/9/10 4:41 PM user-f497 /Volumes/105/PHS00142/work/indd Management Accounting and Corporate Governance EXHIBIT 1.9 EXHIBIT 1.8 PATILLO MANUFACTURING COMPANY Schedule of Inventory Costs Materials Labor Manufacturing overhead* Total product costs Less: Cost of goods sold Ending inventory balance 11 $2,000 3,000 1,000 6,000 (4,000) $2,000 *Depreciation [($4,500 2 $1,500) 4 3] case, the salaries expense for selling and administrative employees and the depreciation on office furniture are period costs reported directly on the income statement. Overhead Costs: A Closer Look Financial Statements Income Statement for 2013 Sales revenue Cost of goods sold Gross margin SG&A expenses Salaries expense Depreciation expenseoffice furniture B Net income R O Balance Sheet as of December 31, 2013 Cash O Finished goods inventory K Office furniture $2,800 Accumulated depreciation (600) S Book value Manufacturing equipment 4,500 Accumulated depreciation (1,000) L Book value E Total assets N Stockholders' equity Common stock T Retained earnings Z Total stockholders' equity , Costs such as depreciation on manufacturing equipment cannot be easily traced to products. Suppose that Patillo Manufacturing makes both tables and chairs. What part of the depreciation is caused by manufacturing tables versus manufacturing chairs? Similarly, suppose a production supervisor oversees employees who work on both tables and chairs. How much of the supervisor's salary relates to tables and how much to chairs? Likewise, the cost of glue used in the production department would be difficult to trace to tables versus chairs. You could count the drops of glue used on each product, but the informationB would not be useful enough to merit the time and money spent collecting the data. R Costs that cannot be traced to products and services in a cost-effective manner are I called indirect costs. The indirect costs incurred to make products are called manufacturing overhead. Some of the items commonly included D manufacturing overhead are in indirect materials, indirect labor, factory utilities, rent of manufacturing facilities, and G depreciation on manufacturing assets. I T CHECK YOURSELF 1.2 2 Lawson Manufacturing Company paid production workers wages of $100,000. It incurred materials costs of $120,000 and manufacturing overhead costs0 $160,000. Selling and adminof istrative salaries were $80,000. Lawson started and completed 1,000 units of product and sold 4 800 of these units. The company sets sales prices at $220 above the average per unit produc4 tion cost. Based on this information alone, determine the amount of gross margin and net income. What is Lawson's pricing strategy called? B Answer Total product cost is $380,000 ($100,000 labor 1 $120,000 materials 1 $160,000 U overhead). Cost per unit is $380 ($380,000 4 1,000 units). The sales price per unit is $600 ($380 1 $220). Cost of goods sold is $304,000 ($380 3 800 units). Sales revenue is $480,000 ($600 3 800 units). Gross margin is $176,000 ($480,000 revenue 2 $304,000 cost of goods sold). Net income is $96,000 ($176,000 gross margin 2 $80,000 selling and administrative salaries). Lawson's pricing strategy is called cost-plus pricing. $ 7,500 (4,000) 3,500 (1,200) (600) $ 1,700 $ 9,000 2,000 2,200 3,500 $16,700 $15,000 1,700 $16,700 edm10890_ch01_002-053.indd Page 12 6/18/10 3:35 PM user-f497 12 /Users/user-f497/Desktop/MHBR165 Chapter 1 EXHIBIT 1.10 Cost Allocation $15 2 hours $30 $15 6 hours $90 Allocation rate $120 8 $15 per labor hour B R O O Since indirect costs cannot be effectively traced to products, they are normally assigned to products using cost allocation, a process of dividing a total cost into K parts and assigning the parts to relevant cost objects. To illustrate, suppose that production workers spend an S eight-hour day making a chair and a table. The chair requires two hours to complete and the table requires six hours. Now suppose that $120 of utilities cost is consumed during the day. How much of the $120 should be assigned to each piece of L furniture? The utility cost cannot be directly traced to each specific piece of furniture, but the piece of furniture that required more E labor also likely consumed more of the utility cost. Using this line of reasoning, it is N rational to allocate the utility cost to the two pieces of furniture based on direct labor hours at a rate of $15 per hour ($120 4 8 hours). The chair would be assigned T $30 ($15 per hour 3 2 hours) of the utility cost and the table would be assigned the Z remaining $90 ($15 3 6 hours) of utility cost. The allocation of the utility cost is , shown in Exhibit 1.10. We discuss the details of cost allocation in a later chapter. For now, recognize that overhead costs are normally allocated to products rather than traced directly to them. B Manufacturing ProductR Cost Summary I As explained, the cost of a product made by a manufacturing company is normally composed of three categories: direct materials, direct labor, and manufacturing D overhead. Relevant information about these three cost components is summarized in G Exhibit 1.11. I T A As you have seen, accounting for 2 Answers to The Curious Accountant 0 depreciation related to manufacturing assets is different from accounting for 4 depreciation for nonmanufacturing 4recorded as depreciation expense. Depreciation on assets. Depreciation on the checkout equipment at Sears is B manufacturing equipment at Schwinn is considered a product cost. It is included first as a part of the cost of U inventory and eventually as a part of the expense, cost of goods sold. Recording depreciation on manufacturing equipment as an inventory cost is simply another example of the matching principle, because the cost does not become an expense until revenue from the product sale is recognized. edm10890_ch01_002-053.indd Page 13 6/18/10 3:36 PM user-f497 /Users/user-f497/Desktop/MHBR165 Management Accounting and Corporate Governance 13 EXHIBIT 1.11 Components of Manufacturing Product Cost Component 1Direct Raw Materials Sometimes called raw materials. In addition to basic resources such as wood or metals, it can include manufactured parts. For example, engines, glass, and car tires can be considered as raw materials for an automotive manufacturer. If the amount of a material in a product is known, it can usually be classified as a direct material. The cost of direct materials can be easily traced to specific products. Component 2Direct Labor The cost of wages paid to factory workers involved in hands-on contact with the products being B manufactured. If the amount of time employees worked on a product can be determined, this cost can usually be classified as direct labor. Like direct materials, labor costs must be easily traced to a R specific product in order to be classified as a direct cost. O Component 3Manufacturing Overhead O Costs that cannot be easily traced to specific products. Accordingly, these costs are called indirect costs. They can include but are not limited to the following: K 1. Indirect materials such as glue, nails, paper, and oil. Indeed, note that indirect materials used in S the production process may not appear in the finished product. An example is a chemical solvent used to clean products during the production process but not a component material found in the final product. L 2. Indirect labor such as the cost of salaries paid to production supervisors, inspectors, and maintenance personnel. E 3. Rental cost for manufacturing facilities and equipment. N T Depreciation. Z Security. The cost of preparing equipment for the manufacturing process (i.e., setup costs). , 4. Utility costs. 5. 6. 7. 8. Maintenance cost for the manufacturing facility and equipment. B R UPSTREAM AND DOWNSTREAM COSTS I Most companies incur product-related costs before and after, as well as during, the D manufacturing process. For example, Ford Motor Company incurs significant research and development costs prior to mass producing a new car model. These upstream costs G occur before the manufacturing process begins. Similarly, companies normally incur I significant costs after the manufacturing process is complete. Examples of downstream costs include transportation, advertising, sales commissions, and bad debts. While T LO 4 Distinguish product costs from upstream and downstream costs. upstream and downstream costs are not considered to be product costs for financial reporting purposes, profitability analysis requires that they be considered in cost-plus pricing decisions. To be profitable, a company must recover the total cost of developing, 2 producing, and delivering its products to customers. 0 4 PRODUCT COSTING IN SERVICE AND MERCHANDISING COMPANIES 4 B Companies are frequently classified as being service, merchandising, or manufacturing businesses. As the name implies, service organizations provide services, rather than physiU cal products, to consumers. For example, St. Jude Children's Hospital provides treatment programs aimed at healing patient diseases. Other common service providers include public accountants, lawyers, restaurants, dry cleaning establishments, and lawn care companies. Merchandising businesses are sometimes called retail or wholesale companies; they sell goods other companies make. The Home Depot, Inc., Costco Wholesale Corporation, LO 5 Explain how product costing differs in service, merchandising, and manufacturing companies. edm10890_ch01_002-053.indd Page 14 6/18/10 3:36 PM user-f497 14 /Users/user-f497/Desktop/MHBR165 Chapter 1 and Best Buy Co., Inc., are merchandising companies. Manufacturing companies make the goods they sell to their customers. Toyota Motor Corporation, Texaco, Inc., and American Standard Companies, Inc., are manufacturing businesses. How do manufacturing companies differ from service and merchandising businesses? Do service and merchandising companies incur materials, labor, and overhead costs? Yes. For example, Ernst & Young, a large accounting firm, must pay employees (labor costs), use office supplies (material costs), and incur utilities, depreciation, and so on (overhead costs) in the process of conducting audits. The primary difference between manufacturing entities and service companies is that the products provided by service companies are consumed immediately. In contrast, products made by manufacturing companies can be held in the form of inventory until they are sold to consumers. Similarly, most labor and overhead costs incurred by merchandising companies result from providing assistance to customers. B These costs are normally treated as selling, general, and administrative expenses rather R accumulated in inventory accounts. Indeed, merthan chandising companies are often viewed as service companies rather than considered a O separate business category. The important point to remember is that all business managers are expected to O control costs, improve quality, and increase productivity. Like managers of manufacturK ing companies, managers of service and merchandising businesses can benefit from the S analysis of the cost of satisfying their customers. For example, Wendy's, a service company, can benefit from knowing how much a hamburger costs in the same manner that Bayer Corporation, a manufacturing company, benefits from knowing the cost of a L bottle of aspirin. E N CHECK YOURSELF 1.3 T The cost of making a Burger King Z hamburger includes the cost of materials, labor, and overhead. Does this mean that Burger King is a manufacturing company? , No, Burger King is not a manufacturing company. It is a service company because its products are consumed immediately. In contrast, there may be a considerable delay between the time the product of a manufacturing company is made and the time it is B consumed. For example, it could be several months between the time Ford Motor Company R makes an Explorer and the time the Explorer is ultimately sold to a customer. The primary difference between service and manufacturing companies is that manufacturing companies I have inventories of products and service companies do not. Answer D G I JUST-IN-TIME INVENTORY T LO 6 Show how just-in-time inventory can increase profitability. Companies attempt to minimize the amount of inventory they maintain because of the high cost of holding it. Many inventory holding costs are obvious: financing, warehouse space, supervision, theft, damage, and obsolescence. Other costs are hidden: diminished 2 motivation, sloppy work, inattentive attitudes, and increased production time. 0 Many businesses have been able to simultaneously reduce their inventory holding costs and increase customer satisfaction by making products available just in time (JIT) 4 for customer consumption. For example, hamburgers that are cooked to order are 4 fresher and more individualized than those that are prepared in advance and stored until a customer orders one. Many fast-food restaurants have discovered that JIT B systems lead not only to greater customer satisfaction but also to lower costs through U reduced waste. Just-in-Time Illustration To illustrate the benefits of a JIT system, consider Paula Elliot, a student at a large urban university. She helps support herself by selling flowers. Three days each week, edm10890_ch01_002-053.indd Page 15 6/18/10 3:36 PM user-f497 /Users/user-f497/Desktop/MHBR165 Management Accounting and Corporate Governance 15 Paula drives to a florist, purchases 25 single-stem roses, returns to the school, and sells the flowers to individuals from a location on a local street corner. She pays $2 per rose and sells each one for $3. Some days she does not have enough flowers to meet customer demand. Other days, she must discard one or two unsold flowers; she believes quality is important and refuses to sell flowers that are not fresh. During May, she purchased 300 roses and sold 280. She calculated her driving cost to be $45. Exhibit 1.12 displays Paula's May income statement. After studying just-in-time inventory systems in her managerial accounting class, Paula decided to apply the B concepts to her small business. She reengineered her distribution system by purchasing her flowers from a florist R within walking distance of her sales location. She had O considered purchasing from this florist earlier but had rejected the idea because the florist's regular selling price of At Ford Motor Company's plant in Valencia, Spain, suppliers feed O $2.25 per rose was too high. After learning about most- parts such as these bumpers just in time and in the right order K favored customer status, she developed a strategy to get a directly to the assembly line. S price reduction. By guaranteeing that she would buy at least 30 roses per week, she was able to convince the local florist to match her current cost of $2.00 per rose. The local florist agreed that she could make purchases in batches of any L size so long as the total amounted to at least 30 per week. Under this arrangement, Paula was able to buy roses just in time to meet customer demand. Each day she purE chased a small number of flowers. When she ran out, she simply returned to the florist N for additional ones. The JIT system also enabled Paula to eliminate the cost of the nonvalue-added activity T of driving to her former florist. Customer satisfaction actually improved because no Z one was ever turned away because of the lack of inventory. In June, Paula was able to buy and sell 310 roses with no waste and no driving expense. The June income state, ment is shown in Exhibit 1.13. Paula was ecstatic about her $115 increase in profitability ($310 in June 2 $195 in May 5 $115 increase), but she was puzzled about the exact reasons for the change. She had B saved $40 (20 flowers 3 $2 each) by avoiding waste and elimiR nated $45 of driving expenses. These two factors explained only I $85 ($40 waste 1 $45 driving expense) of the $115 increase. EXHIBIT 1.12 What had caused the remaining $30 ($115 2 $85) increase in D profitability? Paula asked her accounting professor to help her Income Statement for May G identify the remaining $30 difference. Sales revenue (280 units 3 $3 per unit) $840 The professor explained that May sales had suffered I Cost of goods sold (280 units 3 $2 per unit) (560) from lost opportunities. Recall that under the earlier invenGross margin 280 T tory system, Paula had to turn away some prospective cusDriving expense (45) tomers because she sold out of flowers before all customers Excess inventory waste (20 units 3 2) (40) were served. Sales increased from 280 roses in May to Net income $195 2 310 roses in June. A likely explanation for the 30 unit difference (310 2 280) is that customers who would have 0 purchased flowers in May were unable to do so because of a lack of availability. May's sales suffered from the 4 lost EXHIBIT 1.13 opportunity to earn a gross margin of $1 per flower4on 30 roses, a $30 opportunity cost. This opportunity cost is Income Statement for June B the missing link in explaining the profitability difference between May and June. The total $115 difference consists Sales revenue (310 units 3 $3 per unit) $930 U Cost of goods sold (310 units 3 $2 per unit) (620) of (1) $40 savings from waste elimination, (2) $45 savings from eliminating driving expense, and (3) opportunity cost Gross margin 310 Driving expense 0 of $30. The subject of opportunity cost has widespread application and is discussed in more depth in subsequent Net income $310 chapters of the text. edm10890_ch01_002-053.indd Page 16 6/18/10 3:36 PM user-f497 16 /Users/user-f497/Desktop/MHBR165 Chapter 1 CHECK YOURSELF 1.4 A strike at a General Motors brake plant caused an almost immediate shutdown of many of the company's assembly plants. What could have caused such a rapid and widespread shutdown? A rapid and widespread shutdown could have occurred because General Motors uses a just-in-time inventory system. With a just-in-time inventory system, there is no stockpile of inventory to draw on when strikes or other forces disrupt inventory deliveries. This illustrates a potential negative effect of using a just-in-time inventory system. Answer LO 7 Identify the key components of corporate governance. B R O CORPORATE GOVERNANCE O Corporate governance is the set of relationships between the board of directors, manK agement, shareholders, auditors, and other stakeholders that determine how a company is operated. Until recently, corporations were generally free to govern themselves. HowS ever, several high-profile scandals have motivated governmental authorities to enact legislation designed to influence corporate governance. This section of the chapter examines the factors affecting corporate governance. We examine the motives and means L of management corruption. Further, we introduce the mechanisms for self control E including codes of ethics and internal controls. Finally, we discuss recent legislation designed to influence managerial responsibility for financial reporting. N Management accountants are at the forefront of corporate governance. They are T the guardians of the information used to report on the financial condition of their comZ panies. The information they prepare and analyze is used by the board of directors and company executives to formulate the company's operating strategy. Indeed, manage, ment accountants constitute the intelligence function of corporate governance. Scandals usually begin with schemes to manipulate a company's financial reports and end when the falsification is so great it becomes obvious the reports no longer represent B reality. The appropriate management of the information function is a highly effective R force against corrupt governance. It is little wonder why recent legislation requires the chief financial officer along with the chief executive officer to personally certify that the I company's annual report does not contain false statements nor omit significant facts. D G The Motive to Manipulate Many managers are judged on Itheir company's financial statements or the company's stock price which is determined, in part, by the financial statements. Managers are T rewarded for strong financial statements with promotions, pay raises, bonuses, and stock options. Weak financials can result in a manager being passed over for promotions, demoted, or even fired. It is little wonder that some executives are tempted to manipu2 late financial statements. 0 To illustrate implications of statement manipulation, consider the events experi4 enced by Marion Manufacturing Company (MMC) during its first year of operations. All transactions are cash transactions. 4 1. MMC was started when it acquired $12,000 from issuing common stock. B 2. MMC incurred $4,000 of costs to design its product and plan the manufacturing U process. 3. MMC incurred specifically identifiable product costs (materials, labor, and overhead) of $8,000 to make 1,000 units of product, resulting in a cost per unit of $8 ($8,000 4 1,000 units). 4. MMC sold 700 units of inventory for $18 each. edm10890_ch01_002-053.indd Page 17 7/9/10 4:41 PM user-f497 /Volumes/105/PHS00142/work/indd Management Accounting and Corporate Governance EXHIBIT 1.14 Financial Statements Under Alternative Cost Classification Scenarios Income Statements Scenario 1 Sales revenue (700 3 $18) Cost of goods sold Gross margin Selling and administrative expense Net income $12,600 (5,600)1 7,000 (4,000) $ 3,000 Scenario 2 $12,600 (8,400)3 4,200 0 $ 4,200 B R Assets Cash $12,600 $12,600 O Inventory 2,4002 3,6004 Total assets $15,000 O $16,200 Stockholders' equity K Common stock $12,000 $12,000 Retained earnings 3,000 S 4,200 Total stockholders' equity $15,000 $16,200 L 700 units 3 $8 per unit 5 $5,600 300 units 3 $8 per unit 5 $2,400 E [$5,600 1 ($4,000 3 .70)] 5 $8,400 [$2,400 1 ($4,000 3 .30)] 5 $3,600 N T Exhibit 1.14 displays a balance sheet and income statement prepared under the followZ ing two scenarios. , Balance Sheets 1 2 3 4 Scenario 1: The $4,000 of design and planning costs are classified as selling and administrative expenses. Scenario 2: The $4,000 of design and planning costs B classified as product costs, are meaning they are first accumulated in the Inventory account and then R expensed when the goods are sold. Given that MMC made 1,000 units I and sold 700 units of inventory, 70% (700 1,000) of the design cost has passed through the Inventory account into the Cost of Goods Sold D account, leaving 30% (300 1,000) remaining in the Inventory account. G Statement Differences I Comparing the financial statements prepared under Scenario 1 with those prepared T under Scenario 2 reveals the following. 1. There are no selling and administrative expenses under Scenario 2. The design cost was treated as a product cost and placed into the 2 Inventory account rather than being expensed. 0 2. Cost of goods sold is $2,800 ($4,000 design cost 3 .70) higher under Scenario 2. 4 3. Net income is $1,200 higher under Scenario 2 ($4,000 understated expense 2 $2,800 4 overstated cost of goods sold). B 4. Ending inventory is $1,200 ($4,000 design cost 3 .30) higher under Scenario 2. U Practical Implications The financial statement differences shown in Exhibit 1.14 are timing differences. When MMC sells the remaining 300 units of inventory, the $1,200 of design and planning costs included in inventory under Scenario 2 will be expensed through cost of goods sold. In other words, once the entire inventory is sold, total expenses and retained 17 edm10890_ch01_002-053.indd Page 18 6/18/10 3:36 PM user-f497 18 /Users/user-f497/Desktop/MHBR165 Chapter 1 earnings will be the same under both scenarios. Initially recording cost in an inventory account only delays eventual expense recognition. However, the temporary effects on the financial statements can influence the (1) availability of financing, (2) motivations of management, and (3) timing of income tax payments. Availability of Financing. The willingness of creditors and investors to provide capital to a business is influenced by their expectations of the business's future financial performance. In general, more favorable financial statements enhance a company's ability to obtain financing from creditors or investors. Management Motivation. Financial statement results might affect executive compensation. For example, assume that Marion Manufacturing adopted a management incenB tive plan that provides a bonus pool equal to 10 percent of net income. In Scenario 1, R managers would receive $300 ($3,000 3 0.10). In Scenario 2, however, managers would receive $420 ($4,200 3 0.10). Do not be deceived by the small numbers used for conO venience in the example. We could illustrate with millions of dollars just as well as with hundreds of dollars. Managers O would clearly favor Scenario 2. In fact, managers might be tempted to misclassify costs K manipulate the content of financial statements. to S Income Tax Considerations. Since income tax expense is calculated as a designated percentage of taxable income, managers seek to minimize taxes by reporting the minimum amount of taxable income. Scenario 1 in Exhibit 1.14 depicts the most favorable L tax condition. In other words, with respect to taxes, managers prefer to classify costs as E expenses rather than assets. The Internal Revenue Service is responsible for enforcing the proper classification of costs. Disagreements between the Internal Revenue Service N and taxpayers are ultimately settled in federal courts. T Z Statement of Ethical Professional Practice , The preceding discussion provides some insight into conflicts of interest management accountants might face. It is tempting to misclassify a cost if doing so will significantly increase a manager's bonus. Management accountants must be prepared not only to B make difficult choices between legitimate alternatives but also to face conflicts of a more troubling nature, such as pressure to: R 1. 2. 3. 4. Undertake duties they haveInot been trained to perform competently. Disclose confidential information. D Compromise their integrity through falsification, embezzlement, bribery, and so on. G Issue biased, misleading, or incomplete reports. I To provide management accountants with guidance for ethical conduct the Institute of T Management Accountants (IMA) issued a Statement of Ethical Professional Practice, which is shown in Exhibit 1.15. Management accountants are also frequently required to abide by organizational codes of ethics. Failure to adhere to professional and 2 organizational ethical standards can lead to personal disgrace, loss of employment, or imprisonment. 0 4 4 Unfortunately, it takes more than a code of conduct to stop fraud. People frequently B engage in activities that they know are unethical or even criminal. The auditing profession has determined that the following three elements are typically present when fraud U The Fraud Triangle occurs: 1. The availability of an opportunity. 2. The existence of some form of pressure leading to an incentive. 3. The capacity to rationalize. edm10890_ch01_002-053.indd Page 19 7/9/10 3:39 PM user-f497 /Volumes/105/PHS00142/work/indd Management Accounting and Corporate Governance 19 EXHIBIT 1.15 Statement of Ethical Professional Practice Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values, and standards that guide our conduct. IMA's overarching ethical principles include: Honesty, Fairness, Objectivity, and Responsibility. Members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them. A member's failure to comply with the following standards may result in disciplinary action. Competence Each member has a responsibility to Maintain an appropriate level of professional expertise by continually developing knowledge and skills. Perform professional duties in accordance with relevant laws, regulations, and technical standards. Provide decision support information and recommendations that are accurate, clear, concise, and timely. B Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. R Confidentiality Each member has a responsibility to O Keep information confidential except when disclosure is authorized or legally required. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates' activities to ensure O compliance. K Refrain from using confidential information for unethical or illegal advantage. Integrity Each member has a responsibility to S Mitigate actual conflicts of interest and avoid apparent conflicts of interest. Advise all parties of any potential conflicts. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. Abstain from engaging in or supporting any activity that might L discredit the profession. Credibility Each member has a responsibility to E Communicate information fairly and objectively. Disclose all relevant information that could reasonably be expected to influence an intended user's understanding of the reports, N analyses, or recommendations. T Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. Z Resolution of Ethical Conflict In applying these standards, you may encounter problems identifying unethical behavior or resolving an , ethical conflict. When faced with ethical issues, follow your organization's established policies on the resolution of such conflict. If these policies do not resolve the ethical conflict, consider the following courses of action: Discuss the issue with your immediate supervisor except when it appears that the supervisor is involved. In that case, present the B issue to the next level. If you cannot achieve a satisfactory resolution, submit the issue to the next management level. Communication of such problems to authorities or individuals not employed or R engaged by the organization is not considered appropriate, unless you believe there is a clear violation of the law. I Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action. D Consult your own attorney as to legal obligations and rights concerning the ethical conflict. G I T The three elements are frequently arranged in the shape of a triangle as shown in Exhibit 1.16. 2 Opportunity is shown at the head of the triangle EXHIBIT 1.16 because without opportunity fraud could not exist. The 0 most effective way to reduce opportunities for ethical Opportunity 4 or criminal misconduct is to implement an effective set of internal controls. Internal controls are policies and 4 procedures that a business implements to reduce B opportunities for fraud and to ensure that its objectives will be accomplished. Specific controls are tailored to U meet the individual needs of particular businesses. For example, banks use elaborate vaults to protect cash and safety deposit boxes, but universities have little use for this type of equipment. Even so, many of the same Pressure procedures are used by a wide variety of businesses. Rationalization edm10890_ch01_002-053.indd Page 20 6/18/10 3:36 PM user-f497 20 /Users/user-f497/Desktop/MHBR165 Chapter 1 REALITY BYTES Unethical behavior occurs in all types of organizations. In its 2007 National Government Ethics Survey, the Ethics Resource Center reported its findings on the occurrences and reporting of unethical behavior in local, state, and federal governments. Fifty-seven percent of those surveyed reported having observed unethical conduct during the past year. Unethical conduct was reported most often by those in local governments (63%) and least often at the federal level (52%). The definition of ethical misconduct used in the study was quite broad, ranging from behavior such as an individual putB ting his or her personal interest ahead of the interest of the organization, R to sexual harassment, to taking bribes. The more egregious offences, such as discrimination or taking bribes, were reported much less often O than activities such as lying to customers, vendors, or the public. O Once observed, unethical behavior often was not reported. For example, only 25 percent of observed incidents of the alteration of financial records were reported to supervisors or whistleblower hotlines, and only 54 percent of observed bribes K were reported. S The survey also found that only 18 percent of government entities have ethics and compliance programs in place that could be considered well-implemented. However, where well-implemented programs do exist, observed unethical misconduct is less likely to occur and more likely to be reported. In these entities only 36 percent of respondents said they had observed misconL duct (compared to 57 percent overall), and when they did observe misconduct, 75 percent said they reported it. E N T Z Exhibit 1.17 contains a summary of many of the internal control policies and proce, dures that have gained widespread acceptance. For the complete 2007 National Government Ethics Survey, go to www.ethics.org. Only a few employees turn to the dark side even when internal control is weak and opportunities abound. So, what causes one person to commit fraud and another to B remain honest? The second element of the fraud triangle recognizes pressure as a key R ingredient of misconduct. A manager who is told to either make the numbers or be fired is more likely to cheat than one who is told to tell it like it is. Pressure can come I from a variety of sources, including: D Personal vices such as drugG addiction, gambling, and promiscuity. Intimidation from superiors. I Personal debt from credit cards, consumer loans, mortgage loans or, poor investments. T Family expectations to provide a standard of living that is beyond one's capabilities. Business failure caused by poor decision making or temporary factors such as a poor economy. 2 Loyalty or trying to be agreeable. 0 The third and final element4 the fraud triangle is rationalization. Few individuals of think of themselves as evil. They develop rationalizations to justify their misconduct. 4 Common rationalizations include the following: B U Everybody does it. They are not paying me enough. I'm only taking what I deserve. I'm only borrowing the money. I'll pay it back. The company can afford it. Look what they are paying the officers. I'm taking what my family needs to live like everyone else. edm10890_ch01_002-053.indd Page 21 6/18/10 3:36 PM user-f497 /Users/user-f497/Desktop/MHBR165 Management Accounting and Corporate Governance EXHIBIT 1.17 Common Internal Control Practices Internal Control Practice Explanation Separating duties Separating the duties necessary to complete a task and assigning the separated duties to two or more employees reduces the opportunity for either employee to defraud the company. It would require collusion between the two employees in order to make payment for a fabricated expense. Cheap labor is not a bargain if the employees are incompetent. Employees should be properly trained and have a record that B attests to personal integrity. R Employees in positions of trust should be bonded through insurance policies that protect a company from losses caused O by employee dishonesty. O Forcing extended absences (such as vacations) creates an opportunity for the temporary replacement employee to check K the work of the absent employees. Fraud is difficult to cover up if you are not present to do so. S Employees tend to be more zealous in supporting company policies when they have clear authority to exercise enforcement. Further, they take their work L seriously when they realize more that they cannot shirk responsibility. E Missing documents become apparent when there are gaps in a recorded sequence of numbers. For example, a stolen check N would become apparent if a check register omits a check number. T Keeping money in a safe; holding inventory in locked warehouses; and bolting computers to a desk are examples of using Z physical controls designed to protect assets. , Knowing that inventory will be counted on a regular basis encourages the inventory control manager to maintain documents that support the actual balance of inventory on B hand. Similarly verifying the mileage on a car will encourage employees to use company-owned vehicles for legitimate R business purposes. Regular evaluations and examinations I are strong deterrents to the inappropriate utilization of company-owned assets. Hiring competent personnel Bonding employees Requiring extended absences Establishing clear lines of authority and responsibility Using prenumbered documents Establishing physical controls Performing evaluations at regular intervals D G I Most people are able to resist pressure and the tendency to rationalize ethical or T legal misconduct. However, some people will yield to temptation. What can companies do to protect themselves from unscrupulous characters? The answer lies in personal integrity. The best indicator of personal integrity is past performance. Accordingly 2 companies must exercise due care in performing appropriate background investigations before hiring people to fill positions of trust. 0 4 4 In spite of ethics training and accounting controls, fraud and its devastating conseB quences persist. Enron, WorldCom, and HealthSouth are examples of massive scandals that destroyed or crippled major U.S. corporations in recent years. These high-profile U Sarbanes-Oxley Act of 2002 cases led government officials to conclude that the force of law would be necessary to restore and maintain confidence in the capital markets. The Sarbanes-Oxley (SOX) Act, which became effective July 30, 2002, provides the muscle that Congress hopes will deter future fiascos. SOX affects four groups including: management, boards of directors, external auditors, and the Public Company Accounting Oversight Board (PCAOB). In 21 edm10890_ch01_002-053.indd Page 22 6/18/10 3:36 PM user-f497 22 /Users/user-f497/Desktop/MHBR165 Chapter 1 FOCUS ON INTERNATIONAL ISSUES FINANCIAL ACCOUNTING VERSUS MANAGERIAL ACCOUNTINGAN INTERNATIONAL PERSPECTIVE This chapter has already explained some of the conceptual differences between financial and managerial accounting, but these differences have implications for international businesses as well. With respect to financial accounting, publicly traded companies in most countries must follow the generally accepted accounting prin- B ciples (GAAP) for their country, but these rules can vary from coun- R try to country. Generally, companies that are audited under the auditing standards of the United States follow the standards estab- O lished by the Financial Accounting Standards Board. Most compa- O nies located outside of the United States follow the standards K established by the International Accounting Standards Board. For example, the United States is one of very few countries whose GAAP S allow the use of the LIFO inventory cost flow assumption. Conversely, most of the managerial accounting concepts introduced in this course can be used by businesses in any country. L For example, activity-based costing (ABC) is a topic addressed in Chapter 6 and is used by many companies in the United States. Meanwhile, a study published in Accountancy Ireland* found that approximately one-third of the companies surveyed in Ireland, E the United Kingdom, and New Zealand were also either using ABC, or were considering adopting it. N T Z , this text, we focus on how SOX affects corporate management. While extensive cover- *Bernard Pierce, \"Activity-Based Costing; the Irish Experience: True Innovation or Passing Fad?\" Accountancy Ireland, October 2004, pp. 28-31. age of SOX is beyond the scope of this text, all management accountants should be aware of the following: B SOX holds the chief executive officer (CEO) and the chief financial officer (CFO) R responsible for the establishment and enforcement of a strong set of internal conI trols. Along with its annual report, companies are required to report on the effectiveness of their internal D controls. Also, the company's external auditors are required to attest to the accuracy of the internal controls report. G SOX charges the CEO and the CFO with the ultimate responsibility for the accuI racy of the company's financial statements and the accompanying notes. Even though lower-level managers will likely prepare the annual report, the CEO and T CFO are required to certify that they have reviewed the report and that, to their knowledge, the report does not contain false statements or significant omissions. An intentional misrepresentation is punishable by a fine of up to $5 million and 2 imprisonment of up to 20 years. 0 SOX requires management to establish a code of ethics and to file reports on the 4 code in the company's annual 10K report filed with the Securities and Exchange Commission. 4 SOX demands that management establish a hotline and other mechanisms for the B anonymous reporting of fraudulent activities. Further, SOX prohibits companies from punishing whistleblowers, employees who legally report corporate misconduct. U The accounting profession and government authorities are becoming increasingly intolerant of unethical conduct and illegal activity. A single mistake can jeopardize an accountant's career. A person guilty of white-collar crime loses the opportunity for white-coll