Income Inflation: Absorption Costing vs. variable.(Instructor's Note)

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CASE DESCRIPTION

The primary subject matter of this case concerns income inflation opportunities when GAAP based absorption costing is used as compared to internally used variable costing when more inventory is produced than sold. Secondary issues examined include distinctions between financial and managerial accounting; ethical responsibilities of managers, Certified Public Accountants and Certified Management Accountants; organizational climate of institutions; fixed costs vs. variable costs; and how inaccurate reporting in one year may affect financial statements in other years. This case can be tailored to three different difficulty levels; level two , appropriate for sophomore Principles of Managerial Accounting; level three, appropriate for junior Cost Accounting; and level five, appropriate for graduate level Managerial Accounting. This case is designed to be taught in one-half hour of class time and is expected to require one hour of outside preparation by students.

CASE SYNOPSIS

Robert had no idea how much his life was about to change. He thought he had acquired a "forever" career with a financially strong company. What he had not considered, though, was the effect his new supervisor could have on his career.

This case examines the income inflation opportunities available to unethical managers. These opportunities arise when production exceeds sales and occurs as a result of the differences between absorption costing and variable costing.

An absorption costing income statement is provided at three different sales levels with production remaining constant. The case asks students to use that information to prepare a variable costing income statement at those same levels assuming production remains constant. The case also asks students to differentiate between fixed and variable costs, to discuss ethical choices, and to discuss the "tone at the top".

INSTRUCTORS' NOTES

In General

Generally Accepted Accounting Principles (GAAP) are only required for external financial accounting and reporting. There are no mandatory requirements for a company's own internal financial record keeping. Therefore, each company has the ability to specify how it will account for transactions internally. Of course, a company may choose to simply adopt GAAP internally and also prepare additional reports and analysis to assist with decision making and other operations. Regardless of the internal methods chosen by the company, though, the financial information should accurately reflect operations and not mislead decision makers.

The clear distinction between financial and managerial accounting is clearly highlighted by this case. The case assists students in better recognizing the limits placed on a company's external reporting choices because of GAAP and the freedoms and negative aspects of those freedoms associated with internal, or managerial, accounting. As the case displays, with freedom comes a significant amount of responsibility.

While managers and other executives within an organization may choose to account for financial events and other transactions in any way that they desire, they have a responsibility to present the information in a way that shows the whole financial condition of the organization regardless of the effects such presentation will have on their jobs or compensation. Ultimately, when employees, managers, and other decision makers are not presented with accurate information, poor decisions are made and the results of such poor decisions can often be devastating to the organization. An individual in a key position has an ethical responsibility to look out for the interests of the entire company and not just himself or herself. In this case, the main character, Robert, has to face making a decision in regard to that very fine line.

The case also touches upon the organizational climate of institutions. Normally, the behavior and attitudes displayed by the top officials of the organization trickle down and permeate the employees throughout the rest of the organization. …