Question & Answer

Ethical Decision making – inappropriate allocation of underapplied overhead82 The Australian government has contracted with alternative energy industry organisations to develop new energy technologies. These contracts are sometimes based on cost. Because these organisations are also developing technologies for non-government entities, incentives exist to shift overhead costs to the government, so that commercial operations become more competitive. Because cost allocations are private information, research provides only indirect evidence that this cost shifting occurs. The following vignette is fictional, but it illustrates potential ethical problems that arise when governments use cost-based contracts for product development.   Deep Water Hydro is an hydro-electricity energy company that focuses on innovative research and development solutions for alternative energy supply for both commercial and government agencies. Because one of its commercial contracts fell through last year, the company had fewer jobs than anticipated. Consequently, the company’s overhead costs were underapplied at the end of the year, so an adjustment was made to increase cost of goods sold (also called cost of sales).   Deep Water’s policy is to allocate production overhead as a percentage of direct labour costs for each contract. One of the government contracts completed last year was to develop a hydroelectricity generator that would supply energy from sea water entering Port Philip Bay in Melbourne. The job contract was based on cost-plus-fixed-fee for a total cost of $245 million. The hydro-electricity project was Deep Water’s only government contract last year. Commercial business completed was $105 million, so cost of goods sold (COGS) totalled $350 million.   Disagreement about underapplied overhead adjustment The government official in charge of the contract complained to the federal contract auditor that Deep Water’s underapplied overhead should not have been closed to COGS. Instead, he argued that it should have been allocated on a pro rata basis among the contracts in progress, finished goods, and COGS. The auditor asked to see the cost accounting records and financial statements for the period. Following is an analysis of the direct costs and cost allocations (in millions):   The $350 million in COGS included $245 million for the government contract. When the underapplied overhead ($100 million) was closed to COGS, the government portion of underapplied overhead was $70 million [$100 ´ ($245 ¸ $350)]. Because the contract specified that the government would pay costs plus a fixed amount, the overhead adjustment effectively increased the revenue under the contract by $70 million.   Actual direct labour costs were $150 million, and the pre-adjustment allocated overhead was $300 million. Therefore, the original allocation rate was 200 per cent ($300 ¸ $150) of direct labour cost. Total actual overhead turned out to be $400 million (the $300 million plus the $100 million underapplied). If Deep Water accountants could have perfectly estimated overhead at $400 million and direct labour cost at $150 million, they would have used 267 per cent ($400 ¸ $150) as the allocation rate.   The underapplied overhead amount was material ($100 million out of $400 million, or 25 per cent). Therefore, the government auditor decided that it should have been allocated on a pro rata basis among the three accounts that reflected work done this period: contracts in progress, finished goods, and cost of goods sold. Had this method been used, the adjustment would have been prorated as follows: The government's share of the COGS adjustment would be ($245 ¸ $350) ´ $29.4 million = $20.6 million. When the auditor compared this to the original adjustment of $70 million, she knew the government had been overcharged.   Alternative methods for allocating overapplied or underapplied overhead The auditor offered Deep Water three alternatives for allocating the overhead adjustment. Under governmental contracts, underapplied overhead could be allocated based on direct materials cost, direct labour cost, or total direct costs. If Deep Water uses direct materials, COGS is increased by $25 million, of which the government portion is $17.5 million. If direct labour cost is used, COGS is increased by $33.3 million, of which the government portion is $23.3 million. If total direct cost is used, COGS is increased by $27.3 million, of which the government portion is $20.1 million.   The government and Deep Water must now negotiate to determine the most appropriate proration method.   Required (a)     Is allocating proportionately more cost to government contracts an ethical problem for Deep Water? Why? (b)     When the government pays more than commercial customers pay for work done, does this situation pose a business problem, a social problem or both? Explain. (c)     Discuss the preferences of various stakeholders for this problem, including: ·                     Deep Water managers ·                     Deep Water shareholders ·                     Deep Water commercial customers ·                     Deep Water governmental customers ·                     Deep Water competitors ·                     Australian taxpayers (d)     Is it fair for the government to pay more for products and services than commercial customers pay? Is it fair for taxes to subsidise the overhead costs for a private business? (e)     How can an organisation monitor whether its accounting practices are ethical?             (LO2, 3 and 4)

Carow Corporation purchased, as a held-for-collection investment, $60,000 of the 8%, 5-year bonds of Harrison, Inc. for $65,118, which provides a 6% return. The bonds pay interest semiannually. Prepare Carow’s journal entries for (a) the purchase of the investment, and (b) the receipt of semiannual interest and premium amortization.

Discuss and illustrate how a correction of an error in previously issued financial statements should be handled.

What are the mechanics whereby the central bank raises the rate of interest?

Hawkeye sold farming equipment for $55,000. It bought the equipment four years ago for $75,000, and it has since claimed a total of $42,000 in depreciation deductions against the asset. Explain how to calculate Hawkeye’s adjusted basis in the farming equipment.

Tiny and Tim each owns half of the 100 outstanding shares of Flower Corporation. This year, Flower reported taxable income of $10,000.  In addition, Flower received $20,000 of life insurance proceeds due to the death of an employee (Flower paid $900 in life insurance premiums this year). Flower had $5,000 of accumulated E&P at the beginning of the year.

Flexible budget Helium Industries manufactures glitter balloons used as party accessories. The balloons are bagged in packages of 100 and sold for $20 per pack. The company incurs fixed manufacturing overhead of $25 000 per year and the fixed overhead is applied based on packs produced. Standard costs are: material $8 per unit, direct labour $5 per unit and variable overhead $3 per unit. The marketing manager believes sales for the coming year will be somewhere between 10 000 and 15 000 packs.   Required (a) Prepare a flexible budget for sales of 10 000, 12 000 and 15 000. (Allocate fixed overhead based on the sales volume.) (b) What advantages are there for Helium Industries in using a flexible budget?

In what sense is the at-risk loss limitation rule more restrictive than the tax-basis loss limitation rule?

In the extractive industries, businesses may pay dividends in excess of net income. What is the maximum permissible? How can this practice be justified?

1.       : Most companies have policies that regulate employees’ personal use of work computers during work hours. Some even monitor employee e-mails and track the Web sites that have been visited. Do you consider this type of surveillance to be an invasion of privacy? What are some advantages and disadvantages of restricting employee use of the Internet and e-mail at work?

As discussed in Chapter 1, the International Accounting Standards Board (IASB) develops accounting standards for many international companies. The IASB also has developed a conceptual frameworkto help guide the setting of accounting standards. While the FASB and IASB have issued converged concepts statements on the objective and qualitative characteristics, other parts of their frameworks differ. Instructions Briefly discuss the similarities and differences between the FASB and IASB conceptual frameworks as  related to elements and their definitions.

What is a “wash sale”? What is the purpose of the wash sale tax rules?

a.       Because Nikki’s 28.57% discount ($14,000 – $10,000/$14,000) is less than Shine Company’s gross profit percentage, the bargain purchase from her employer does not result in taxable income. b.     Nikki will recognize $25 of taxable income from the discounted services provided by Shine Company.  Discounts more than 20% for services are taxable. Thus, Nikki’s taxable discount is $25 ($125 Discount received – (20% x $500)=$25).

When is the cost of education deductible as an employee business expense?

Geraldo recently won a lottery and chose to receive $100,000 today instead of an equivalent amount in ten years, computed using an 8 percent rate of return.  Today, he learned that interest rates are expected to increase in the future.  Is this good news for Geraldo given his decision?

Why is an overvalued exchange rate likely to encourage the use of capital-intensive technology?

How does the tax treatment of a partial liquidation differ from a stock redemption?

At the end of the current year, Pociek Co. has prior service cost of $9,150,000. Where should the prior service cost be reported on the balance sheet?

Why is biology so closely associated with nanoscience and nanotechnology?

Russell Corporation sold a parcel of land valued at $400,000. Its basis in the land was $275,000. For the land, Russell received $50,000 in cash in year 0 and a note providing that Russell will receive $175,000 in year 1 and $175,000 in year 2 from the buyer.    a. What is Russell’s realized gain on the transaction?   b. What is Russell’s recognized gain in year 0, year 1, and year 2?

Your client, Cascade Company, is planning to invest some of its excess cash in 5-year revenue bonds issued by the county and in the shares of one of its suppliers, Teton Co. Teton’s shares trade on the over-the-counter market. Cascade plans to classify these investments as trading. They would like you to conduct some research on the accounting for these investments. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Since the Teton shares do not trade on one of the large securities exchanges, Cascade argues that the fair value of this investment is not readily available. According to the authoritative literature, when is the fair value of a security “readily determinable”? (b) How is an impairment of a debt investment accounted for? (c) To avoid volatility in their financial statements due to fair value adjustments, Cascade debated whether the bond investment could be classified as held-for-collection; Cascade is pretty sure it will hold the bonds for 5 years. What criteria must be met for Cascade to classify it as held-for-collection?

Briefly discuss the convergence efforts that are underway in the area of intangible assets.

In a continuous processing situation (such as an oil refinery), the beginning and ending WIP inventories are frequently the same. How does this simplify determination of equivalent units completed?

A 1-8 UNC low carbon steel bolt (diameter = 1.0 in, 8 threads/in) is currently planned for a certain application. It is to be preloaded to 75% of its proof strength, which is 33,000 lb/in2 (Table 32.2). However, this bolt is too large for the size of the components involved, and a higher strength but smaller bolt would be preferable. Determine (a) the smallest nominal size of an alloy steel bolt (proof strength = 120,000 lb/in2) that could be used to achieve the same preload from the following standard UNC sizes used by the company: 1/4-20, 5/16-18, 3/8-16, 1/2-13, 5/8-11, or 3/4-10; and (b) compare the torque required to obtain the preload for the original 1-in bolt and the alloy steel bolt selected in part (a) if the torque coefficient in both cases = 0.20.

Carolyn Keene, Inc. decided to establish a petty cash fund to help ensure internal control over its small cash expenditures. The following information is available for the month of April. 1. On April 1, it established a petty cash fund in the amount of $200. 2. A summary of the petty cash expenditures made by the petty cash custodian as of April 10 is as follows. Delivery charges paid on merchandise purchased $60.00 Supplies purchased and used 25.00 Postage expense 33.00 I.O.U. from employees 17.00 Miscellaneous expense 36.00 The petty cash fund was replenished on April 10. The balance in the fund was $27. 3. The petty cash fund balance was increased $100 to $300 on April 20. Instructions Prepare the journal entries to record transactions related to petty cash for the month of April.