Question

In Fall 2016, you are hired as Controller of the Medical Device division of Virtek. You report to Steve Slack, the General Manager of the division. Virtek has annual sales of approximately $1.7 billion. The Medical Device Division annual sales are approximately $170 million, about 10% of Virtek’s total annual sales. The Medical Device Division had a very good 2016. As you close the books for 2016 in January 2017, you are reporting a net profit of $21.6 million, well above the 2016 target profit of $20 million for the division. After reviewing the preliminary 2016 financial statements, Steve Slack says,

“We get our bonuses as long as we meet or exceed our $20 million target for net profit. It doesn’t help us to exceed the target by more than one and a half million, that will only encourage corporate to make our target that much higher for 2017. I want you to develop a rational for increasing our reserve for inventory obsolescence that will reduce our 2016 net profit to just over $20 million.”

By taking a pessimistic view of future market prospects, you are able to identify $1.25 million worth of inventory that under those market conditions could be justifiably fully reserved (written off) using conservative accounting. Steve Slack is pleased with the results you reported to him. He said,

“That’s very good! I’m fairly confident we can sell all that inventory in 2017 without offering any more than a small discount off our regular price. That will boost our 2017 net profit by nearly $1 million. With that extra cushion, we’re almost certain to achieve our 2017 earnings targets and our bonuses. I want you to book that adjusting entry to increase our inventory reserve for obsolescence. Oh, by the way, are you sure you can’t find another $200,000 or so of inventory we could write off in the same manner? It wouldn’t hurt to have even more of a cushion.”

You were a little uncomfortable reviewing inventory for obsolescence with a specific target value in mind, and following the meeting with Steve Slack, you decide that before you book the adjusting entry to increase the inventory reserve for obsolescence as he instructed, you want to review the entire situation before proceeding.

Required

Write a memo to Steve Slack in good form. Your memo should:

Identify the ethical issues you both face.

Identify the major stakeholders involved and state how the stakeholders would be affected by the course of action ordered by Steve Slack.

Explain why you believe the course of action proposed by Steve Slack (identifying inventory that can be written down for 2016 that will likely be sold at no more than a small discount to normal prices in 2017) is ethical or unethical.

Regardless of whether you believe the course of action proposed by Steve Slack is ethical or unethical, identify an ethical alternative to his proposed course of action. Recommend one course of action, and explain and support your recommended choice.

Answer 1

MEMORANDUM

To: Steve Slack

From: (Enter your name)

Date: 28/02/2018

Subject: Reporting of Inventory

Steve this is in respect of our discussion in regard to the value of stocks to be reported in our books of accounts. It would be unethical on my part to report the stock at the value which doesnot reflect its fair value since as per you we would be able to sell it by offering some discount on the same. We are liable for our actions to the management & this plan raises a question on our loyalty and dedication to the organisation.

This step will also mislead our investors since we will be reporting EPS (earning per share) of lower amount than the true value. The taxes we pay will be aversely affected. The management will not be able to ascertain the true efficiency & performance of the department since its decision would be based on incorrect figures.

As per the Accounting standards, the inventory should be booked at cost or net realisable value-whichever is lower. Your proposal to book the same at nil value is unethical since we could sell it and therefore it has a realisable value. It should not be written off in the books for the same reason.

The alternative course of action in this case would be to report the inventory at the the value which we expect it to be sold off which would be lower than the cost since it is comprised of obsolete products. This would be in line with the accounting principles. The expected sales value can be kept at the amount which would be lower than its expected amount. This way the profits for this year would be reduced & increased for next year.