Question

LO 2) Aston Corporation performs year-end planning in November of each year before its calendar year ends in December. The preliminary estimated net income is $3 million. The CFO, Rita Warren, meets with the company president, J. B. Aston, to review the projected numbers. She presents the following projected information.

ASTON CORPORATION PROJECTED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2017
Sales		$28,995,000
Interest revenue		5,000
Cost of goods sold	$14,000,000
Depreciation	??2,600,000
Operating expenses	??6,400,000	?23,000,000
Income before income tax		6,000,000
Income tax		??3,000,000
Net income		$?3,000,000

ASTON CORPORATION SELECTED BALANCE SHEET INFORMATION AT DECEMBER 31, 2017
Estimated cash balance	$?5,000,000
Available-for-sale debt investments (at cost)	?10,000,000
Fair value adjustment (1/1/17)	—0—

Estimated fair value at December 31, 2017:

Security	Cost	Estimated Fair Value
A	$?2,000,000	$?2,200,000
B	??4,000,000	??3,900,000
C	??3,000,000	??3,100,000
D	??1,000,000	??1,800,000
Total	$10,000,000	$11,000,000

Other information at December 31, 2017:

Equipment	$3,000,000
Accumulated depreciation (5-year SL)	1,200,000
New robotic equipment (purchased 1/1/17)	5,000,000
Accumulated depreciation (5-year DDB)	2,000,000

The corporation has never used robotic equipment before, and Warren assumed an accelerated method because of the rapidly changing technology in robotic equipment. The company normally uses straight-line depreciation for production equipment.

Aston explains to Warren that it is important for the corporation to show a $7,000,000 income before taxes because Aston receives a $1,000,000 bonus if the income before taxes and bonus reaches $7,000,000. Aston also does not want the company to pay more than $3,000,000 in income taxes to the government.

Instructions

(a)  

What can Warren do within GAAP to accommodate the president's wishes to achieve $7,000,000 in income before taxes and bonus? Present the revised income statement based on your decision.

(b)  

Are the actions ethical? Who are the stakeholders in this decision, and what effect do Warren's actions have on their interests?

Answer 1

(a) The only option before Warren to achieve President's wish is to use straight line method of depreciation instead of the double declining balance method of depreciation for the robotic equipment. The depreciation under SL method would be $5,000,000 / 5 = $1,000,000 instead of $2,000,000.

Revised Income Statement :

Aston Corporation
Projected Income Statement
For the year ended December 31, 2017
Sales		$28,995,000
Interest Revenue		$5,000
Cost of Goods Sold	$14,000,000
Depreciation1	$1,600,000
Operating Expenses	$6,400,000	$22,000,000
Income before Income Taxes		$7,000,000
Unrealized holding gain on Trading Investments2		$1,000,000
Income before Taxes and Bonus		$8,000,000
Bonus		$1,000,000
Taxable Income		$7,000,000
Income Tax Expense
Current Tax Expense	$3,000,000
Deferred Tax Expense3	$500,000	$3,500,000
Net Income		$3,500,000

1. Depreciation of $2,600,000 for the current year includes $600,000 for the old equipment, and $2,000,000 for the robotic equipment. If the depreciation method on the latter is changed to straight-line, depreciation expense is only $ 1,000,000 and total depreciation expense for the year is only $1,600,000.

2. If the classification of the investments is changed from available-for-sale to trading, unrealized holding gain of $ 1,000,000 can be recognized in the income statement, instead of in OCI.

3. Unrealized holding gain contributes to a temporary difference between accounting income and taxable income, as it will be taxed only in the year in which the investments are actually sold. Therefore the tax on the unrealized holding gain will be treated as a deferred tax expense.

Therefore current tax liability is only $3,000,000, and is in accordance with the president's plan.

(b) No, the actions are not ethical, because

i. These actions lead to an overstatement of income of the current year, which will lead to overstatement of assets and retained earnings in future years.

ii. The stakeholders of the financial statements are deprived of the true and fair view of the operating results of the business and financial position

iii. These actions are initiated only to appease the company president, who is only interested in how much money he makes from the company. He is supposed to be protecting the interests of the investors. Hence there is conflict of interest, and breach of trust.

The stakeholders in the decision:

• The existing stockholders of the company, as they are probably going to make poor economic decisions on the basis of distorted financial information
• Potential investors.
• The government, as they will collect lower taxes.
• J.B. Aston, who is the initiator of the earnings management.