Question

Case Study

Mary Tappin, an assistant Vice President at Galaxy Toys, was disturbed to find on her desk a memo from her boss, Gary Resnick, to the controller of the company. The memo appears below:

GALAXY TOYS INTERNAL MEMO

Sept 15

To: Harry Wilson, Controller

Fm: Gary Resnick, Executive Vice President

As you know, we won't start recording many sales until October when stores start accepting shipments from us for the Christmas season. Meanwhile, we are producing flat-out and are building up our finished goods inventories so that we will be ready to ship next month.

Unfortunately, we are in a bind right now since it looks like the net income for the quarter ending on Sept 30 is going to be pretty awful. This may get us in trouble with the bank since they always review the quarterly financial reports and may call in our loan if they don't like what they see. Is there any possibility that we could change the classification of some of our period costs to product costs, such as the rent on the finished goods warehouse?

Please let me know as soon as possible. The President is pushing for results.

Mary didn't know what to do about the memo. It wasn't intended for her, but its contents were alarming.

Required:

Q1:a. Why has Gary Resnick suggested reclassifying some period costs as product costs? (i.e., what is the reason behind such a suggestion and why do you think reclassifying period costs to product costs will improve the net operating income?)

Q2:b. Why do you think Mary was alarmed about the memo? (You might think of it from ethical and other perspectives).

Answer 1

Q. 1

Gary Resnick has suggested reclassifying some period costs as product costs because he is concerned that the net income for the quarter ending on September 30 is going to be dismal due to low sales. The reason for this suggestion by Gary Resnick has logic behind it. All product costs are recognized on the income statement as expenses incurred for producing the finished goods and as such, these costs will be carried over to the next quarter. If the finished goods remain unsold at the end of the quarter, the costs of those unsold goods are treated as assets. On the other hand, period costs are recognized on the income statement as expenses in the current period which are treated as expenses incurred, regardless of whether the finished goods produced are sold or not. Therefore, by asking the Controller Harry Wilson, to reclassify the period costs, such as warehouse rent, as product costs, Gary Resnick is trying to carry forward some of the costs in the form of inventories which should have otherwise been considered as expenses for September quarter.

Would the reclassification of period costs to product costs will improve the net operating income? Yes it will improve the net operating income for the current September quarter by overstating the income because of understating of both the cost of goods sold and the expenses. Let me illustrate the impact of reclassification of period costs to product costs with the help of a hypothetical income statement of the company before and after conversion of warehouse rent into a period cost. Assume that the sales are $100, opening inventory of 5, ending inventory of 15, purchases of 50 and warehouse rent of 20. The cost of goods sold before conversion will be 5+50-15 = 40. The cost of goods sold after conversion will be (5+50) - (15+20) = 20.

Income statement

Before Conversion After Conversion

Sales 100 100

Less cost of goods sold 40 20

Gross income 60 80

Less Expenses: Warehouse rent   20 0

Net Income 40 80

Gary Resnick therefore, did have good logic behind his suggestion.

Q. 2

Mary Tappin was alarmed about the memo about the proposed attempt to reclassify period costs as product costs because it is not ethical to tinker with the financial statements of the company by violating the established rules and protocols for financial reporting. Supposing. if the Controller, Harry Wilson, does not idisclose this reclassification in the financial statements of Galaxy Toys, this will result in reporting not only an inflated income for the September quarter but also an inflated shareholder's equity due to inflated income. The inflated income and shareholder's equity would mislead the readers of the financial statements of Galaxy Toys. The trend of earnings would also be affected. This reclassification is also a violation of the principle of consistency in financial reporting. Moreover, not only Galaxy Toys will have to pay more taxes for the September quarter, this step of reporting inflated income and shareholder's equity can also be considered as an attempt to falsify the financial statements which could invoke severe penalties from the regulatory bodies.

Conclusion:

Mary Tappin should discuss with Gary Resnick and Harry Wilson all the relevant aspects and possibe adverse implications of the reclassification of period costs to product costs as explained above to dissuade them from undertaking this step.