Question

Your company uses absorption costing for preparing its GAAP-based income statement and balance sheet. Management is disappointed because its external auditors are requiring it to write off an inventory amount because because the inventory balance exceeds what the company could reasonably sell in the foreseeable future.

1. Discuss what might have motivated managers to produce more than they could sell. Support your contention with a numerical example of how they might benefit.

2. Assuming managers receive a bonus based on profit, why would management be disappointed about the write-off?

3. Are their ethical considerations?

Answer 1

Answer -

1. The managers would have considereded possible inflation that might occur in the near future leading to increase in prices of raw materials and other variable cost to be incurred for production process. So comparing the cost of production in advance plus the storage cost with cost of manufacturing at a later stage, the management would have found an opportunity to earn more even in the inflation stage.

Numerical Example -

Suppose Production of [Product name] "Alpha" requires

Raw Material AB

Raw Material MN

Their current prics are $2 and $5. One unit of Alpha can be produced using 1 unit of AB and 1 unit of MN.

The storage cost per unit is $1/quarter. Management expects that due to low supply of AB and MN their price will soon rise to $8 and $10 respectively. So comparing the following,

What management will have to incur today / unit	What management will have to incur in future / unit
Manufacturing & storage Cost - $8	Manufacturing & storage Cost - $19

motivated the managers to produce more than they could sell.

2. Managers would be disappointed because managers anticipated the same amount of demand even in near future and analysing future conditions today managers in order to enable to company to maintain and grow its profits took a decision to produce more. Writing off the inventory will lead to decrease in profits and assets owned by the company, managers even after working hard and considering factors to take decisions leading to company's profit in future will be disappointed because this decison would ruin their dedicationa and hard work in just a moment.

3. Consideration are not ethical from external auditors because, the responsibility of External Auditor is to check for material misstatement and provide an opinion on the Financial Statement and not to make judgements on entity's business and its strategies towards business unless their are illegal.