Question

Toronto Stock Exchange. In a meeting with investment analysts at the beginning of the year, Jones had predicted that the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Jones concluded within two weeks of the end of the fiscal year that it would ultimately be impossible to report an increase in earnings as large as predicted unless some drastic action were taken. As a result, Jones ordered that wherever possible, expenditures should be postponed to the new year—including cancelling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-year advertising and travel. Also, Jones ordered the company’s controller to carefully scrutinize all costs that are currently classified as period costs and reclassify as many as possible as product costs. The company is expected to have substantial inventories of work in process and finished goods at the end of the year.

Required:

1. Why would reclassifying period costs as product costs increase this period’s reported earnings?

2. Do you believe Adam Jone's actions to be ethical? Why, or why not? (Be descriptive and explain)

Answer 1

Part 1)

Period cost is reported as as an expense in the income statement in the period in which it is incurred by the company. Product costs indicate costs that are incurred in the manufacturing of the product. Such costs are reported in the income statement (as cost of goods sold) only when the corresponding units are sold by the company. Therefore, any number of units unsold at the end of the relevant period will continue to remain in inventory (which is an asset) and the cost of such units will be carried forward to the next accounting period. A reclassification of period costs as product costs will result in an increase in the cost of inventory with the amount that should have been reported as expense in the current period. This will finally result in a transfer of current year costs to future years. As a result, the company will be able to report lower expenses in the income statement and increase the earnings for the current period.

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Part 2)

No, Adam Jone's action is not ethical. The intention behind reclassification of costs is to report an increase in the earnings for the current period. The financial statements with such a reclassification will not provide correct information to the users of financial statements. While higher profits may get reported in the current year, the company's profitability in future years will get affected because of such a reclassification. This can affect the earnings trend of the company and it may become difficult for the investors to understand the financial viability of the company on an year to year to basis. Further, any mispresentation in the financial statements can affect the market reputation and goodwill of the company. Investors and other stakeholders may lose confidence in the company's management and its business practices.