Question

Eric Johnson was recently promoted to Controller of Research and Development (R&D) for PharmaCor, a Fortune 500 pharmaceutical company, which manufactures prescription drugs and nutritional supplements. The company’s total R&D cost for 2012 was expected (budgeted) to be $5 billion. During the company’s mid-year budget review, Eric realized that current R&D expenditures were already at $3.5 billion, nearly 40% above the mid-year target. At this current rate of expenditure, the R&D division was on track to exceed its total year-end budget by $2 billion! In a meeting with CFO, James Clark, later that day, Johnson delivered the bad news. Clark was both shocked and outraged that the R&D spending had gotten out of control. Clark wasn’t any more understanding when Johnson revealed that the excess cost was entirely related to research and development of a new drug, Lyricon, which was expected to go to market next year. The new drug would result in large profits forPharma Cor, if the product could be approved by year-end.
Clark had already announced his expectations of third quarter earnings to Wall Street analysts. If the R&D expenditures weren’t reduced by the end of the third quarter, Clark was certain that the targets he had announced publicly would be missed and the company’s stock price would tumble. Clark instructed Johnson to make up the budget short-fall by the end of the third quarter using “whatever means necessary.” Johnson was new to the Controller’s position and wanted to make sure that Clark’s orders were followed.
Johnson came up with the following ideas for making the third quarter budgeted targets:
a. Stop all research and development efforts on the drug Lyricon until after year-end. This change would delay the drug going to market by at least six months. It is also possible that in the meantime a Pharma Cor competitor could make it to market with a similar drug.
b. Sell off rights to the drug, Markapro. The company had not planned on doing this because, under current market conditions, it would get less than fair value. It would, however, result in a onetime gain that could offset the budget short-fall. Of course, all future profits from Markapro would be lost.
c. Capitalize some of the company’s R&D expenditures reducing R&D expense on the income statement.This transaction would not be in accordance with GAAP, but Johnson thought it was justifiable, sincethe Lyricon drug was going to market early next year. Johnson would argue that capitalizing R & D costs this year and expensing them next year would better match revenues and expenses.
Required: 1. Referring to the “Standards of Ethical Behavior for Practitioners of Management Accounting which of the preceding items (a–c) are acceptable to use? Which are unacceptable?
2. What would you recommend Johnson do?

Answer 1

Standards of Ethical Behavior for Practiioers Management issued by Institute of Management Accontants highlights duties of managemet accountants with regard to "Integrity" of the profession.

The standard requies a Management Accountant to communicate favourable & unfavourable information and professional judgements & opinions & refrain from either actively or passively subverting the attainment of the organization's legitimate and ethical objectives.

a. Johnson wants to stop all the frther expenditure on the drug at the cost of possbility that a competitor company can develop the same drug & seize the market share. This is detrimental the legitimate objectives of Pharma Cor of developing drugs & making profit in the long range. This will affect the profits for the future years which are to follow . So its not ethical on part Johnson to stop the research activity .

b. Sell of the drugs would also deprive the company from future profits which may affect next few year's results as against the gain of managing just one year's budget shortfall. If the share price would go down this year ( after the budget gap is communicated) , it's bound to go up next year when the new drug is released. It's in favour of long term gains of the company that the drug is not sold below the fair value.

c. Capitalization of R & D expenses is not accroding to GAAP. That would be unethical as well as illlegal for a listed company.

As per the Standard of ehtical behaviour a management accountant should refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically.

Treating R & D expenses contrary to GAAP in books of accounts is not at all recommended.

2. As per the etical standards, its also a duty of a management accountant to  avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict.

I would recommend Johnson to communicate to Clark that its in best interest of the company that the budget overexpenditure should be communicated to all the stakeholders. Alongwith, he should also communicate the stage of research for the new drug & the expected release date & a profit estimate for future years. This will reduce the fall in stock price .

( Many times the Excutive officers advise the financial results not disclosing the adverse information because that affects the share price which in turn affects the incentives paid to these position. Because of these implication the high level enctives tend to take a yearly approach than to take long term approach. This is not ethical & not in terms of the company as well the public at large.

So every time when there is a possiblity that the Executive officer at a high level position wants to hide any information for a specific year then it should be invstigated whether the organisation is going to loose gains for future years).