We have had Paige & Gentry as our auditors for many years,havenât we, Jane? They have been here since I became president twoyears ago.â âYes, Bob, I have been the Chief Financial Officer forseven years, and they were here before I came. Why do you ask?ââWell, they were really tough on us during the recent discussionswhen we were finalizing our year-end audited statementsânot at alllike I was used to at my last company. When we asked for a littlelatitude, our auditors were usually pretty obliging. Frankly, Iâm alittle worried.â âWhy, Bob, we had nothing to hide?â âThatâs true,Jane, but letâs look ahead. Weâre going to have difficulty makingour forecast this year, and our bonuses are on the line. Remember,we renegotiated our salary/bonus package to give us a chance athigher incentives, and we have to be careful.â âLooking ahead,weâve got a problem with obsolete inventory thatâs sure to come torequire discussion for a second year in a row. Weâve got thewarranty problem with the electrical harness on midrange machinewhich is going to cost us a bundle, but we want to spread theimpact over the next three years when the customers discover theproblem and we have to fix it up. And donât forget the contaminatedwaste spill we just hadâhow much is that going to cost to clean up,if we ever get caught?â âThese are potentially big ticket items.Bill Paige, the guy who is in charge of our audit, is not going tolet these go by. He said the inventory problem was almost materialthis year and we had to argue really hard. You are a qualifiedaccountant; how can we handle this?â âWell, Bob, we could have someinformal discussions with other auditorsâmaybe even the ones atyour old companyâto see how they would handle issues like these.The word will get around to Bill and he may be more accommodatingin the future, and will probably shave his proposed audit fee fornext year when he meets with our Audit Committee next month. If youreally wanted to play hardball, we could talk the Audit Committeeinto calling for tenders from new auditors. After all this time,itâs logical to check out the market, anyway. We would have advancediscussions during which we would sound them out on how they wouldassess materiality in our companyâs case. Our audit fee in gettingpretty largeâalmost $50,000 this yearâso some big firms will bereally interested.â âJane, letâs play hardball. Get a list of auditfirms together for the tender process, and I will approach theAudit Committee. Be sure to list some small firms, includingWebster & Co., the firm auditing my old company.â Questions 1.Who are the major stakeholders involved in this situation? 2. Whatare the ethical issues involved? 3. Is this situation unethical?Why and why not? 4. What should Jane do if Webster & Co. lookslike the choice the Audit Committee will make and recommend to theboard of directors?
We have had Paige & Gentry as our auditors for many years,havenât we, Jane? They have been here since I became president twoyears ago.â âYes, Bob, I have been the Chief Financial Officer forseven years, and they were here before I came. Why do you ask?ââWell, they were really tough on us during the recent discussionswhen we were finalizing our year-end audited statementsânot at alllike I was used to at my last company. When we asked for a littlelatitude, our auditors were usually pretty obliging. Frankly, Iâm alittle worried.â âWhy, Bob, we had nothing to hide?â âThatâs true,Jane, but letâs look ahead. Weâre going to have difficulty makingour forecast this year, and our bonuses are on the line. Remember,we renegotiated our salary/bonus package to give us a chance athigher incentives, and we have to be careful.â âLooking ahead,weâve got a problem with obsolete inventory thatâs sure to come torequire discussion for a second year in a row. Weâve got thewarranty problem with the electrical harness on midrange machinewhich is going to cost us a bundle, but we want to spread theimpact over the next three years when the customers discover theproblem and we have to fix it up. And donât forget the contaminatedwaste spill we just hadâhow much is that going to cost to clean up,if we ever get caught?â âThese are potentially big ticket items.Bill Paige, the guy who is in charge of our audit, is not going tolet these go by. He said the inventory problem was almost materialthis year and we had to argue really hard. You are a qualifiedaccountant; how can we handle this?â âWell, Bob, we could have someinformal discussions with other auditorsâmaybe even the ones atyour old companyâto see how they would handle issues like these.The word will get around to Bill and he may be more accommodatingin the future, and will probably shave his proposed audit fee fornext year when he meets with our Audit Committee next month. If youreally wanted to play hardball, we could talk the Audit Committeeinto calling for tenders from new auditors. After all this time,itâs logical to check out the market, anyway. We would have advancediscussions during which we would sound them out on how they wouldassess materiality in our companyâs case. Our audit fee in gettingpretty largeâalmost $50,000 this yearâso some big firms will bereally interested.â âJane, letâs play hardball. Get a list of auditfirms together for the tender process, and I will approach theAudit Committee. Be sure to list some small firms, includingWebster & Co., the firm auditing my old company.â Questions 1.Who are the major stakeholders involved in this situation? 2. Whatare the ethical issues involved? 3. Is this situation unethical?Why and why not? 4. What should Jane do if Webster & Co. lookslike the choice the Audit Committee will make and recommend to theboard of directors?
Related questions
Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own; rather, it relies completely on independent sales agents to market its products. These agents are paid a sales commission of 15% for all items sold.
Barbara Cheney, Pittmanâs controller, has just prepared the companyâs budgeted income statement for next year as follows:
| Pittman Company Budgeted Income Statement For the Year Ended December 31 | ||||||
| Sales | $ | 18,500,000 | ||||
| Manufacturing expenses: | ||||||
| Variable | $ | 8,325,000 | ||||
| Fixed overhead | 2,590,000 | 10,915,000 | ||||
| Gross margin | 7,585,000 | |||||
| Selling and administrative expenses: | ||||||
| Commissions to agents | 2,775,000 | |||||
| Fixed marketing expenses | 129,500 | * | ||||
| Fixed administrative expenses | 1,900,000 | 4,804,500 | ||||
| Net operating income | 2,780,500 | |||||
| Fixed interest expenses | 647,500 | |||||
| Income before income taxes | 2,133,000 | |||||
| Income taxes (30%) | 639,900 | |||||
| Net income | $ | 1,493,100 | ||||
*Primarily depreciation on storage facilities.
As Barbara handed the statement to Karl Vecci, Pittmanâs president, she commented, âI went ahead and used the agentsâ 15% commission rate in completing these statements, but weâve just learned that they refuse to handle our products next year unless we increase the commission rate to 20%.â
âThatâs the last straw,â Karl replied angrily. âThose agents have been demanding more and more, and this time theyâve gone too far. How can they possibly defend a 20% commission rate?â
âThey claim that after paying for advertising, travel, and the other costs of promotion, thereâs nothing left over for profit,â replied Barbara.
âI say itâs just plain robbery,â retorted Karl. âAnd I also say itâs time we dumped those guys and got our own sales force. Can you get your people to work up some cost figures for us to look at?â
âWeâve already worked them up,â said Barbara. âSeveral companies we know about pay a 7.5% commission to their own salespeople, along with a small salary. Of course, we would have to handle all promotion costs, too. We figure our fixed expenses would increase by $2,775,000 per year, but that would be more than offset by the $3,700,000 (20% Ã $18,500,000) that we would avoid on agentsâ commissions.â
The breakdown of the $2,775,000 cost follows:
| Salaries: | |||
| Sales manager | $ | 115,625 | |
| Salespersons | 693,750 | ||
| Travel and entertainment | 462,500 | ||
| Advertising | 1,503,125 | ||
| Total | $ | 2,775,000 | |
âSuper,â replied Karl. âAnd I noticed that the $2,775,000 equals what weâre paying the agents under the old 15% commission rate.â
âItâs even better than that,â explained Barbara. âWe can actually save $85,100 a year because thatâs what weâre paying our auditors to check out the agentsâ reports. So our overall administrative expenses would be less.â
âPull all of these numbers together and weâll show them to the executive committee tomorrow,â said Karl. âWith the approval of the committee, we can move on the matter immediately.â
Required:
1. Compute Pittman Companyâs break-even point in dollar sales for next year assuming:
a. The agentsâ commission rate remains unchanged at 15%.
b. The agentsâ commission rate is increased to 20%.
c. The company employs its own sales force.
2. Assume that Pittman Company decides to continue selling through agents and pays the 20% commission rate. Determine the dollar sales that would be required to generate the same net income as contained in the budgeted income statement for next year.
3. Determine the dollar sales at which net income would be equal regardless of whether Pittman Company sells through agents (at a 20% commission rate) or employs its own sales force.
4. Compute the degree of operating leverage that the company would expect to have at the end of next year assuming:
a. The agentsâ commission rate remains unchanged at 15%.
b. The agentsâ commission rate is increased to 20%.
c. The company employs its own sales force.
Use income before income taxes in your operating leverage computation.
ââJust one,ââ John saidand itâs only an idea that you might wantto pitch to the management
team along with these other changes. We have used the percent ofaccounts receivable method to
calculate our Allowance for Bad Debt for several years. But wedonât have to use that method.ââ
ââWhat do you mean?ââElsa asked. ââIsnât the percent of accountsreceivable method one of the
best ways to calculate the Allowance?ââ
ââTechnically, yes, it is. However, we recently hired a newcredit manager who has improved
our collections and tightened our credit policy for newcustomers. Because of these improvements,
we might not have to use the percent of accounts receivablemethod. Instead, we could switch back
to the percent of sales method that we used previously. Byswitching from using 12 percent of
accounts receivable to 2 percent of credit sales, we wouldreduce our allowance for bad debts
and our bad debt expense. That would offset some of thesenegative changes we have just discussed.ââ
ââWhat were credit sales for the year?ââ Simon asked.
ââAbout $1.25 million, and accounts receivable had an endingbalance of $600,000 after we
wrote off $30,000 of uncollectible accounts. We wrote off almost$50,000 the year before, so our
collections really have improved. Honestly, I donât think thatweâd lose information quality by
switching methods. We donât really have to use any specificmethod for estimating bad debt
expense. I think we could make a case for the more relaxedestimation method, and I think the
positive effect of the change on net income might help themanagement team accept some of these
other adjustments.ââ Elsa jumped in.
ââI donât see any problem with that.ââ Simon frowned.
ââIâm not sure I like the idea of changing methods solely tooffset the negative
effects of these other adjustments. But go ahead and calculatehow switching methods would affect
our bad debt expense. Weâll meet again tomorrow morning, afterIâve talked with Jane and Doug
about how to handle these issues.ââ
Estimate 1 | Estimate 2 | |
Current Sales Price | $750 | $600 |
Historical Cost | $850 | $850 |
Replacement Cost | $700 | $500 |
Disposal Cost | $65 | $70 |
Typical Markup | $200 | $175 |
Units in Inventory | 62 | 62 |
a. Based on the information provided in the take, calculate thewrite-down that would be necessary using the first set ofassumptions.
b. Based on the information provided in the table claculate thewrite-down that would be necessary using the second set ofassumptions.
c. Assuming that Frosty Co.'s management team decided to use thefist set of estimates, what correcting entries wouldd need to bemade to write down inventory? (assume that Frosty Co. uses thedirect write-off method)
d. What correcting entries would need to be made to write downinventory if the team decided to use the second set ofestimates?
e. What would be the net effect of each of these inventoryadjustments on net income? what would be the net effect on EPS?
