Question

Milton Manufacturing Company produces a variety of textiles for distribution to wholesale manufacturers of clothing products. The company’s primary operations are located in Long Island City, New York, with branch factories and warehouses in several surrounding cities. Milton Manufacturing is a closely held company, and Irv Milton is the president. He started the business in 2008, and it grew in revenue from $500,000 to $5 million in 10 years. However, the revenues declined to $4.5 million in 2018. Net cash flows from all activities also were declining. The company was concerned because it planned to borrow $20 million from the credit markets in the fourth quarter of 2019.

Irv Milton met with Ann Plotkin, the chief accounting officer (and also a CPA), on January 15, 2019, to discuss a proposal by Plotkin to control cash outflows. He was not overly concerned about the recent decline in net cash flows from operating activities because these amounts were expected to increase in 2019 as a result of projected higher levels of revenue and cash collections. However, that was not Plotkin’s view.

Plotkin knew that if overall negative capital expenditures continued to increase at the rate of 40 percent per year, Milton Manufacturing probably would not be able to borrow the $20 million. Therefore, she suggested establishing a new policy to be instituted on a temporary basis. Each plant’s capital expenditures for 2019 for investing activities would be limited to the level of those capital expenditures in 2017, the last year of an overall positive cash flow. Operating activity cash flows had no such restrictions. Irv Milton pointedly asked Plotkin about the possible negative effects of such a policy, but in the end, he was convinced that it was necessary to initiate the policy immediately to stem the tide of increases in capital expenditures. A summary of cash flows appears in Exhibit 1.

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EXHIBIT 1
MILTON MANUFACTURING COMPANY
Summary of Cash Flows
For the Years Ended December 31, 2018 and 2017 (000 omitted)
	December 31, 2018							December 31, 2017
Cash Flows from Operating Activities
Net income			$	372						$	542
Adjustments to reconcile net income to net cash provided by operating activities				(2,350	)						(2,383	)
Net cash provided by operating activities			$	(1,978	)					$	(1,841	)
Cash Flows from Investing Activities
Capital expenditures			$	(1,420	)					$	(1,918	)
Other investing inflows (outflows)				176							84
Net cash used in investing activities			$	(1,244	)					$	(1,834	)
Cash Flows from Financing Activities
Net cash provided (used in) financing activities			$	168						$	1,476
Increase (decrease) in cash and cash equivalents			$	(3,054	)					$	(2,199	)
Cash and cash equivalents—beginning of the year			$	3,191						$	5,390
Cash and cash equivalents—end of the year			$	147						$	3,191

Sammie Markowicz is the plant manager at the headquarters in Long Island City. He was informed of the new capital expenditure policy by Ira Sugofsky, the vice president for operations. Markowicz told Sugofsky that the new policy could negatively affect plant operations because certain machinery and equipment, essential to the production process, had been breaking down more frequently during the past two years. The problem was primarily with the motors. New and better models with more efficient motors had been developed by an overseas supplier. These were expected to be available by April 2019. Markowicz planned to order 1,000 of these new motors for the Long Island City operation, and he expected that other plant managers would do the same. Sugofsky told Markowicz to delay the acquisition of new motors for one year, after which time the restrictive capital expenditure policy would be lifted. Markowicz reluctantly agreed.

Milton Manufacturing operated profitably during the first six months of 2019. Net cash inflows from operating activities exceeded outflows by $1,250,000 during this time period. It was the first time in two years that there was a positive cash flow from operating activities. Production operations accelerated during the third quarter as a result of increased demand for Milton’s textiles. An aggressive advertising campaign initiated in late 2018 seemed to bear fruit for the company. Unfortunately, the increased level of production put pressure on the machines, and the degree of breakdown was increasing. A big problem was that the motors wore out prematurely.

Markowicz was concerned about the machine breakdown and increasing delays in meeting customer demands for the shipment of the textile products. He met with the other branch plant managers, who complained bitterly to him about not being able to spend the money to acquire new motors. Markowicz was very sensitive to their needs. He informed them that the company’s regular supplier had recently announced a 25 percent price increase for the motors. Other suppliers followed suit, and Markowicz saw no choice but to buy the motors from the overseas supplier. That supplier’s price was lower, and the quality of the motors would significantly enhance the machines’ operating efficiency. However, the company’s restrictions on capital expenditures stood in the way of making the purchase.

Markowicz approached Sugofsky and told him about the machine breakdowns and the concerns of other plant managers. Sugofsky seemed indifferent but reminded Markowicz of the capital expenditure restrictions in place and that the Long Island City plant was committed to keeping expenditures at the same level as it had in 2017. Markowicz argued that he was faced with an unusual situation and he had to act now. Sugofsky hurriedly left, but not before he said to Markowicz, “You and I may not agree with it, but a policy is a policy.”

Markowicz reflected on his obligations to Milton Manufacturing. He was conflicted because he viewed his primary responsibility and that of the other plant managers to ensure that the production process operated smoothly. The last thing the workers needed right now was a stoppage of production because of machine failure.

At this time, Markowicz learned of a 30-day promotional price offered by the overseas supplier to gain new customers by lowering the price for all motors by 25 percent. Coupled with the 25 percent increase in price by the company’s supplier, Markowicz knew he could save the company $1,500, or 50 percent of cost, on each motor purchased from the overseas supplier.

After carefully considering the implications of his intended action, Markowicz contacted the other plant managers and informed them that while they were not obligated to follow his lead because of the capital expenditure policy, he planned to purchase 1,000 motors from the overseas supplier for the headquarters plant in Long Island City.

Markowicz made the purchase at the beginning of the fourth quarter of 2019 without informing Sugofsky. He convinced the plant accountant to record the $1.5 million expenditure as an operating (not capital) expenditure because he knew that the higher level of operating cash inflows resulting from increased revenues would mask the effect of his expenditure. In fact, Markowicz was proud that he had “saved” the company $1.5 million, and he did what was necessary to ensure that the Long Island City plant continued to operate.

The acquisitions by Markowicz and the other plant managers enabled the company to keep up with the growing demand for textiles, and the company finished the year with record high levels of profit and net cash inflows from all activities. Markowicz was lauded by his team for his leadership. The company successfully executed a loan agreement with Second Bankers Hours & Trust Co. The $20 million borrowed was received on October 3, 2019.

During the course of an internal audit of the 2019 financial statements, Beverly Wald, the chief internal auditor (and also a CPA), discovered that there was an unusually high number of motors in inventory. A complete check of the inventory determined that $1 million worth of motors remained on hand.

Wald reported her findings to Ann Plotkin, and together they went to see Irv Milton. After being informed of the situation, Milton called in Sugofsky. When Wald told him about her findings, Sugofsky’s face turned beet red. He told Wald that he had instructed Markowicz not to make the purchase. He also inquired about the accounting since Wald had said it was wrong.

Wald explained to Sugofsky that the $1 million should be accounted for as inventory, not as an operating cash outflow: “What we do in this case is transfer the motors out of inventory and into the machinery account once they are placed into operation because, according to the documentation, the motors added significant value to the asset.”

Sugofsky had a perplexed look on his face. Finally, Irv Milton took control of the accounting lesson by asking, “What’s the difference? Isn’t the main issue that Markowicz did not follow company policy?” The three officers in the room shook their heads simultaneously, perhaps in gratitude for being saved the additional lecturing. Milton then said he wanted Wald and Plotkin to discuss the alternatives on how best to deal with the Markowicz situation and present the choices to him in one week.

Case Overview

This case deals with a company’s efforts to manage its short-term earnings and cash outflows by restricting capital expenditures.

Top managements’ decision to restrict capital expenditures created a conflict for Sammie Markowicz, the plant manager at the headquarters location in Long Island City. On the one hand, Markowicz knows that the company expects him to follow company policy. On the other hand, he is very conscious of his primary responsibility to keep the production process operating as efficiently as possible. Markowicz was placed in a difficult position because of the capital expenditure restrictions, especially in light of the previously experienced machine breakdowns. The conflict comes to a head for Markowicz when he learns about the 25% price increase that is announced by the plant’s primary supplier for motors used in the production process.

Markowicz’ decision to order 1,000 of the motors for the Long Island City plant influences other plant managers to take similar actions. He acted in a way that he thought would be in the best interest of the company even though it violated company policy. He failed to consider the consequences of his action on the stakeholders. At a minimum, Markowicz could have contacted top management with his dilemma and sought a reversal of the policy by emphasizing the more frequent machine break downs and pending price increase. Markowicz was wrong to hide the acquisition of an asset by charging it to expense. This action violates the rights of the stockholders who rely on accurate financial information. Markowicz’s action were primarily motivated by self-interest (reasoning at stage 2) and not out of concern for the interests of the stakeholders. An issue that should be dealt with by the company is how and why Markowicz was able to circumvent the interest controls and override the policy.

Some students may argue that Markowicz did the right thing; he saved the company a lot of money; kept the production process flowing; and best served customer needs. All of this is true but Markowicz’s ethics were situational and the problem is what if another employee/manager decides in the future to take matters into his own hands, regardless of company policy, and make a decision that may be in his best interests without considering all stakeholder interests. The company has a right to expect its employees to be faithful to its policies and not violate them for some sense of a “greater good.” Even though the policy may have been short-sighted, the way to handle it would have been for Markowicz to have an open and honest conversation with all relevant parties before deciding what action he would take. He owed that to top management as a trusted employee.

Use the Integrated Ethical Decision-Making Process to guide you in answering the following:

Questions to answer:

1. Identify the ethical and professional issues of concern to Beverly Wald and Ann Plotkin.

2. Identify and evaluate alternative courses of action using ethical reasoning.

3. Explain how the moral intensity of the situation might influence ethical action.

4. Decide on a course of action to present to Milton. Why did you select that alternative?

Answer 1

1.

The ethical and professional issues for Beverly Wald are the recording, integrity, due care, transparency and fair disclosure of accounting transactions and the resulting financial statements. There could be question of whether the bank would have made the loan if the proper accounting treatment had been reflected in the financial statements. Markowicz convinced the plant accountant to treat the expenditure as an operating expense, not a capital expenditure which was the appropriate accounting. Wald can’t let the Cash Flow Statement go forward with this error. A major concern is how Markowicz circumvented internal controls. There seems to have been no checks and balances in the system before Markowicz made the expenditure. Wald should be concerned with the policies and internal controls to prevent such circumvention in the future. She should also consider whether the company culture encourages employees to act with integrity, objectivity, and due care. How can the culture be changed? Is it only through policies? She also needs to consider that how this matter is handled will contribute to whether the company’s control environment fosters ethical or unethical behavior.

2.

The stakeholders in this case are Milton, shareholders, Wald, Plotkin, Sugofsky, Markowicz, other plant managers, the plant accountants and other employees. Other stakeholders include Second Bankers Hours & Trust Co., creditors, customers, the communities where the plants are located, and the public. Milton and the shareholders want the company to be profitable and provide a return on their investment. Wald, Plotkin, Sugofsky, Markowicz, other plant managers and employees want a good job at an ethical, sustainable company. Second Bankers Hours & Trust Co. and creditors want their loans to be secured, able to be repaid with interest, and able to rely on financial statements. The customers want a quality product at a competitive price and dependable delivery dates. The communities and the public want a good corporation citizen which provides jobs and pays taxes. Employees want the security of knowing their jobs are secure.

3.

Wald, Plotkin, and Sugofsky may consider the following alternatives.

• The company can pretend that management did not know or notice the violation of the policy. This alternative may be a rationalization of act-utilitarianism. The company used the new motors to increase inventory, sales, and obtain borrowed funds. Since everything seems to have worked for good, no need to take any other action, or the ends justified the means of breaking policies. The company could counsel Markowicz to not do it again.
• The company could restate the financial statements. This would be supported by virtue theory. Once the company makes the restatement, it should inform the lender.
• Further the company could decide to publicly punish Markowicz to temper any future insubordination. The punishment could range from a reprimand to being fired. This alternative would be supported by rule-utilitarianism. Rights Theory would also support this alternative. The company had a right to expect the Markowicz to follow its directives; Markowicz had a duty to meet the company’s expectations. The company could fire Sugofsky, who did not listen or negotiate on the issue, in addition to Markowicz. Or the company could privately reprimand Markowicz and publicly let other employees know the importance of doing the right thing and being ethical. In any case, ethical training is called for to make sure this does not happen again and establish better controls as to how to handle such matters..

4.

Being in Milton’s place, alternative 2 of restating the financial statements and letting the lender know should be chosen. Further the punishment of Markowicz and Sugofsky should be considered to set an ethical tone in the firm. Still, the company has to examine its own behavior – unbending policies – and lack of effective communication. Employees should feel comfortable to bring matters to their superiors and able admit to mistakes. In this case, if Markowicz had felt comfortable in explaining the plan to purchase the motors with Sugofsky or other superiors, the firm could have re-considered the policy at least this one time and made plans for the number of motors to be purchased and which plants were to receive the motors. This would be acting with integrity, transparency and would be supported by virtues, deontology, and utilitarianism. In the end, the best thing to do might be give a stern warning to Markowicz (maybe put it in writing and place it in his file) and have staff training to establish clear reporting channels when this kind of thing happens again.