“The GAP in GAAP”

1. “The GAP in GAAP” The IMA Northern Lights Regional Conference, April 27, 2012 Olen L. Greer, Ph.D., CMA Professor of Accountancy

2. Heartland Regional Council Professional Education Conference • When: September 19 and 20, 2012 • Where: University Plaza Hotel & Convention Center, Springfield, Missouri • Conference Details: • 16 hours of CPE. • Nationally known speakers (e.g. Chester Elton, author of The Carrot Principle, Tom Schweich, MO State Auditor, Economist AnirbanBasu and many others). • Includes 10 general sessions and 6 sets of 3 concurrent sessions. • Registration ($370/$395) includes breakfast, lunch & breaks for both days. • Corporate Discounts available.

3. BACKGROUND and PROBLEM DEVELOPMENT

4. “Respect” and The Accounting Profession “The Way We Were” as of 1986 (per the President of the MSCPA’s) Clergy Medical Doctors Attorneys Accountants THE MOST RESPECTED PROFESSIONALS: __________

5. “Respect” and The Accounting Profession Then came Enron, World Com, Tyco, etc.

6. “Respect” and The Accounting Profession,Continued “Ultimately, the accounting profession sacrificed the public confidence that underpinned its reputation. Now, accountants wallow at the bottom among professions in public-opinion polls they topped 20 years ago. The business is drawing fewer top students, more government scrutiny and bad jokes.” “No Taste for Accounting,” I. J. Dugan, WSJ

7. “Respect” and The Accounting Profession,Continued “Hard hit by industry scandals, industry leaders and individual accountants will need to put their best feet forward to rebuild a now tarnished image and restore public faith in what was once a most trusted profession.” “If the Shoe Fits,” C. Fitzgerald, Insight

8. Central Scandal Theme: ________________________________

9. “And check for this red flag: Are net earnings (as reported on the income statement) increasing while cash flow is declining? That could signal the use of creative accounting practices designed to ____________________________________________________. Exhibit A: Enron.”“10QuestionsEvery Investor Should Ask Before Buying a Stock,”J. Revell, Fortune

10. “When it comes to reporting earnings, U.S. companies have about as much credibility these days as the judges of Olympic figure skating. So how do you begin to restore investor confidence post-Enron, post-Tyco, post-you-name-it? By having companies state profits in a way that is more meaningful and _____________________________________________________.”“System Failure,” Joseph Nocera, Fortune

11. What was the “fix?” Sarbanes-Oxley (2002)

12. SOX legislation impact: • The compliance burden on MA’s has increased, to the point that they have little-to-no time to focus on management’s needs. • Management must now survive 3 audit opinions, instead of one. • Corporate America has already (as of 2006) spent over $280 billion complying with SOX (Non-value adding costs). Source: “Surviving Three SOX Opinions,” Crawford, Klamm & Watson, Strategic Finance, May, 2007.

13. SOX legislation impact, Continued: • The cost per company, per year, ranges from _______to well over ____________. This is a totally non-value adding expense. Source: “2011 Sarbanes-Oxley Compliance Survey,” conducted and published by PROVITY Risk and Business Consulting.

14. GAAP

15. Purposes of Presentation • To examine income measurement problems CREATED BY GAAP-REQUIRED COSTING METHODOLOGIES. • To demonstrate how GAAP encourages and incentivizes managers to manipulate income in LEGAL ways that can be extremely harmful to the organization.

16. The Income Equation Revenue – EXPENSES = Profit

17. -COST- “A sacrifice made (economic or otherwise) to obtain a desired benefit.”

18. Cost Accounting 101GAAP Product Costing-Absorption Costing • Product Costs • _____________________________________ • _____________________________________ • _____________________________________ • Period Costs • _____________________________________ • _____________________________________

19. Review Quiz Results 6. ___________________ = ___________________ ___________________

20. Sources of Variation (GAAP) • Cost flow assumptions (FIFO, LIFO, etc.) • Cost Allocation Methods • Actual vs. Normal vs. Standard Cost Systems • Service Department Cost Allocations: Direct vs. Step vs. Algebraic Methods • Joint Cost Allocations: Physical vs. Sales Value at Splitoff vs. Approximated Net Realizable Value • Activity-Based Costing vs. Traditional Methods • ETC. . . . . . . . . . . . . . . . . .

21. Traditional Income Formula:Sales – Cost of Goods Sold = Gross MarginGross Margin – S&A Expenses = Operating Income

22. Practicum No. 1The Olga Bonemarrow Company

23. The Olga Bonemarrow Wood Spirits Company produces two products, turpentine and methanol (wood alcohol), by a joint process. • Joint costs amount to $120,000 per batch of output. • Each batch totals 10,000 gallons, 25% methanol and 75% turpentine.

24. Both products are processed further without gain or loss in volume. • Separable processing costs: Methanol, $3 per gallon; Turpentine, $2 per gallon. • Methanol sells for $21 per gallon; Turpentine sells for $14 per gallon. • Bonemarrow uses the approximated net realizable value method for allocating joint costs to main products.

25. QUESTIONS • What amounts of Joint Costs would be allocated to Methanol? Turpentine? ________________________________________________________________________________________________________________________________________________________________________

26. QUESTIONS, Continued • What is the total cost of each product and the per unit cost of each product? ________________________________________________________________________________________________________________________________________________________________________

27. QUESTIONS, Continued • What is the Gross Margin on each product and the Gross Margin percentage? ____________________________________________________________________________________________________________________________________________

28. Suppose that you are the manager of the Methanol Division. • Furthermore, suppose that you and your staff worked hard to develop a process by which the methanol could be made into a pleasant-tasting beverage.

29. The new selling price would be $48 per gallon (net of Excise Tax). • The additional separable cost of the new process would be $9.00, bringing the total separable cost per gallon to $12.00 ($9 + $3).

30. QUESTIONS • What amounts of Joint Costs would be allocated to the new product? Turpentine? ________________________________________________________________________________________________________________________________________________________________________

31. QUESTIONS, Continued • What is the total cost of each product and the per unit cost of each product? ________________________________________________________________________________________________________________________________________________________________________

32. QUESTIONS, Continued • What is the Gross Margin on each product and the Gross Margin percentage? ____________________________________________________________________________________________________________________________________________

33. Olga Bonemarrow Summary • Use of a GAAP-sanctioned cost allocation method resulted ______ __________________________. • Long-term impact: ___________ __________________________. • REMEMBER: Allocated joint costs are generally _________ to product decisions.

34. ASSERTION: The GAAP answer to the “Cost Question” is, in many if not most cases, the WRONG answer, when it comes to decision making.

35. The Fixed Cost Dilemma • GAAP requires FFOH to be allocated to products. • By allocating FFOH to products, we’re forcing a fixed cost to behave ____________ ____________________________________. • The amount we allocate to each unit is dependent on _________________________. • We don’t know how many units we’re going to produce until the end of the period!!

36. Practicum No. 2The Brassinni Company

37. The Brassinni Company began operations in 2010 as a manufacturer with a capacity of 40 million units of product.In 2010, 10 million units of product were manufactured and sold. Brassinni Company’s income statement for 2010 follows:

38. BRASSINNI COMPANY Income Statement Year ending December 31, 2010 Sales (10 million units @ $6) $60,000,000 Cost of Goods Sold: Variable(10,000,000 @ $2) $20,000,000 Fixed 48,000,000 Total 68,000,000 Gross Margin ($8,000,000) Less: Marketing & Admin. Costs 10,000,000 Operating Profit (Loss) ($18,000,000)

39. The board of directors is concerned about the $18 million loss. A consultant approached the board with following offer: “I agree to become president for no fixed salary. But, I insist on a year-end bonus of 10 percent of operating profit (before considering the bonus).” The board of directors agreed to these terms and hired the consultant.The new president promptly stepped up production to an annual rate of 30 million units. Sales for 2011 remained at 10 million units. The income statement for Brassinni Company for 2011 follows:

40. BRASSINNI COMPANYIncome StatementYear ending December 31, 2011 Sales (10 million units @ $6) $60,000,000Cost of Goods Sold: Variable (30,000,000 @ $2)$_________ Fixed 48,000,000 Cost of Goods Mf’d$_________ Less: Ending Inventory: Variable (20,000,000 x $2)$_________ Fixed (20/30 x 48,000,000)_________ Total, Ending Inventory _________ Cost of Goods Sold __________ Gross Margin $__________Less: Marketing & Admin. Costs 10,000,000 Operating Profit before Bonus $__________Less: Bonus __________ Operating Profit after Bonus $__________

41. The day after the statement was verified, the president took his check for $1,400,000 and resigned to take a job with another corporation. He remarked, “I enjoy challenges. Now that Brassinni Company is in the black, I’d prefer tackling another challenging situation.” (His contract with his new employer is similar to the one he had with Brassinni Company.)

42. What’s WRONG with this picture?

43. BRASSINNI COMPANYVariable Costing Income StatementYear ending December 31, 2011 Sales (10 million units @ $6) $60,000,000 ____________________: _________________________________________ _______________________________________ Less: Ending Inventory: _________________________________________ Variable Cost of Goods Sold 20,000,000 Contribution Margin $_________ Less: Fixed Costs: ________________________________________ Marketing & Admin. Costs 10,000,000 Total Fixed Costs: _________ Operating Profit (Loss) before Bonus __________ Less: Bonus __________ Operating Profit (Loss) after Bonus ___________

44. Cost Accounting 201Variable Costing • Basic Premise of Variable Costing: FFOH (Capacity Costs) are costs of “being in business.” • Therefore, FFOH should be treated as a Period Cost, rather than a Product Cost (as required by GAAP and Absorption Costing).

45. Cost Accounting 201Variable Costing, Continued • Products inventoried using variable production costs only (direct material, direct labor, and variable factory overhead). • Income Statement Format: Contribution Margin Format.

46. Cost Accounting 201Variable Costing, Continued Income Formula: Sales – Variable Expenses = Contribution Margin Contribution Margin – Fixed Expenses = Operating Income

47. The Brassinni CompanyVariable Costing Income StatementYear ending December 31, 2011 Sales (10 million units @ 6$) $60,000,000 Variable Cost of Goods Sold: Variable (30 mil @ 2$) $60,000,000 Variable Cost of Goods Mf’d $60,000,000 Less: Ending Inventory: Variable Costs (20 mil x $2) $40,000,000 Variable Cost of Goods Sold 20,000,000 Contribution Margin $40,000,000

48. The Brassinni CompanyVariable Costing Income Statement, ContinuedYear ending December 31, 2011 Contribution Margin $40,000,000 Less: Fixed Costs: Fixed Factory Overhead $48,000,000 Marketing & Admin. Costs 10,000,000 Total Fixed Costs: 58,000,000 Operating Profit (Loss) before Bonus ($18,000,000) Less: Bonus 1,400,000 Operating Profit (Loss) after Bonus ($19,400,000)

49. The BrassinniCompany, Summary Total impact of actions by President of Brassinni Company on: Reported Net Income: _____________________________________________ _____________________________________________ Cash Flow: _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________

50. Absorption Costing • Income is a function of • ______________________________ • ______________________________ • Income can be manipulated by ___________ ____________________________________. • Phantom Profits are created. • Cash Flow is destroyed!