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In: Finance

Earnings Management M. K. Gallant is president of Kranbrack Corporation, a company whose stock is traded...

Earnings Management

M. K. Gallant is president of Kranbrack Corporation, a company whose stock is traded on a national exchange. In a meeting with investment analysts at the beginning of the year, Gallant had predicted that the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Gallant concluded within two weeks of the end of the fiscal year that it would be impossible to report an increase in earnings as large as predicted unless some drastic action was taken. Accordingly, Gallant has ordered that wherever possible, expenditures should be postponed to the new year—including canceling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-year advertising and travel. Additionally, Gallant 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 at the end of the year.

Using the above scenario, your textbook, and a minimum of one outside source, address the following questions: Why would reclassifying period costs as product costs increase this period’s reported earnings? Do you believe Gallant’s actions are ethical? Why or why not?

Solutions

Expert Solution

1.Period costs are not a necessary part of the manufacturing process. As a result, period costs cannot be assigned to the products or to the cost of inventory. The period costs are usually associated with the selling function of the business or its general administration. The period costs are reported as expenses in the accounting period in which they 1) best match with revenues, 2) when they expire, or 3) in the current accounting period.

Product-based costing provides little flexibility in the way that overhead costs are allocated to finished goods. Even if costs are allocated to products in a weighted fashion based on a variable-like cycle time or direct labor, the system is not robust enough to accurately reflect the complicated flow of product in a plant that produces multiple products of different complexity. This can lead to either over-costing or under-costing -- allocating too much or too little overhead to an individual product -- and can also mask inefficiencies in the production system due to its broad application.

Allocation of periodic cost on product basis can reduce cost allocation for certain period but it will not be an effective method on a long run basis.

2. Actions taken by gallent's are not ethical because reduction of expenditures for a year-including canceling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-year advertising and travel will stop company future growth as postponing order will reduce inventory required to produce finished goods in future and may create some shortage of inventory,Planning ,maintenance,Training & advertisement are crucial part of any business which cannot be denied as these process are continuous process require at various level to run a business.

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