Question

Ethics involved with capital budgeting proposal (Learning Objectives 1, 2, 3, 4, & 5)

Carlson Products, Inc., is a manufacturer of a variety of construction products, including insulation, pipe, and gypsum. The company has been experiencing steady growth over the past few decades and is moderately profitable.

The board of directors at Carlson has developed criteria that all capital budgeting projects undertaken at Carlson must meet in order to be approved:

1. The project’s net present value (NPV) must be positive. The company uses a hurdle rate of 10% when calculating NPV.

2. The project’s payback period must be less than four years.

3. The project’s accounting rate of return (ARR) must be greater than 8%.

Samantha Pace is a division manager at Carlson. She is developing a proposal to install solar panels at the company’s Flagstaff, Arizona, manufacturing facility. The solar panels, requiring an investment of $1.25 million, will significantly reduce the company’s carbon footprint. The project will help the company to save approximately 25% of its current energy costs at that facility. Samantha is excited about this project, both for its dollar savings and for its sustainability impact. She finalizes the calculations for the capital budgeting criteria for the solar panel proposal and is delighted to see that her proposed project meets all of the company’s capital budgeting criteria. She sends the proposal to Peter Nichols, the controller for Carlson. Peter is responsible for approving all proposed capital budgeting projects that require less than a $2 million investment. Carlson’s board of directors must approve all capital budgeting projects that require more than a $2 million investment.

Peter reviews the solar panel proposal. He thinks it is a promising project and feels that the company should undertake this project and other sustainability projects so that the company can reduce its environmental impact.

As he double checks the calculations in Samantha’s proposal, he discovers that she has made a few mistakes. Instead of using a hurdle rate of 10%, she actually used a hurdle rate of 6%. She also did not include the impact of the annual depreciation expense for the solar panels in the calculation of ARR. If Peter makes the corrections, the solar panel project will fail the NPV criteria and the ARR criteria.

Peter is conflicted over what to do. He knows that no one is likely to discover Samantha’s errors in the capital budgeting proposal if he approves it; the errors are not obvious. He really wants to approve the project, since he believes strongly that these types of initiatives are the direction in which Carlson Products needs to head in order to remain competitive in the future. He also can rationalize that the impact of the errors is minimal and that the project does not fail the capital budgeting criteria by a significant margin. On the other hand, he knows that the board of directors of Carlson has been rigid in its application of the capital budgeting criteria in the projects it has reviewed.

Requirements

1. Using the IMA Statement of Ethical Professional Practice as an ethical framework, answer the following questions:

   1. What is(are) the ethical issue(s) in this situation?

   2. What are Peter’s responsibilities as a management accountant? Should he approve the solar panel project? Why or why not?

2. Are there any better alternative courses of action that Peter might take to resolve this conflict than to simply approve or reject the proposal? Support your answer.

Answer 1

a. The ethical issues are that Samantha has used a lower hurdle rate than the approved guidelines to increase the present value of the cash flows. Peter although discovers these errors, does not correct them owing to the company's pressure to perform and sustain competition.

b. Peter's responsibilty as a management accountant relavant to the situation as per IMA guidelines include:

(i) Comptence : To provide decision support information and recommendation in a timely, clear and concise manner

(ii) Mitigate actual conflicts of interest ad refrain from carrying out activities that may be against integrity.

(iii) Refrain from engaging in any activity that may discredit the profession

(iv) Communicate fairly and objectively.

Peter is in a leadership position and must see corrective action is taken rather than support Samantha although the decision may be difficult one. He must act in accordance with the IMA's guidelines. Also , he can look for alternative ways to make the project a profitable one.

2. Alternatives available to Peter are:

1. Recast the cash flows after analysis to increase the NPV. The increase however must be realistic.

2. Depreciation must be added after the after tax income since the NPV will be positive.

3. The IRR of the project must be calculated and check if it is above the hurdle rate. If it is higher than the hurdle the project can be accepted.

4. He can alternatively discuss the project with the senior management and check if the project can be taken after the mistakes have been corrected. Not all projects with a negative NPV are unprofitable.