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M.K. Gallant is president of Kranbrack Corporation, a company whose stock is traded on a national exchange. In a meeting with investment analysts at the beginning of the year, Gallant had predicted that the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Gallant concluded with two weeks of the end of the fiscal year that it would impossible to ultimately report an increase in earning as large as predicted unless some drastic action was taken. Accordingly, Gallant has ordered that wherever possible, expenditures should be postponed to the new year – including canceling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-the-year advertising and travel. Additionally, Gallant ordered the company’s controller to carefully scrutinize all costs that are currently classified as period costs and reclassify as many as possible as product costs. The company is expected to have substantial inventories of work in process and finished goods at the end of the year.

Why would reclassifying period costs as product costs increase this period’s reported earnings?
Do you believe Gallant’s actions are ethical? Why or why not?

  • Ethics -

    If they are product costs, they could be carried on the books until the product is sold, making a short term "reduction" in costs.

    Ethical? It is smoke and mirrors, it is legal, and it does hide costs that ultimately will need to be paid.

    If I were the accounting firm certifying the balance sheet, it would be worthy of an accounting note on the statement.

  • Ethics/business -

    Reclassifying period costs (which are mainly administrative and advertising costs) as product costs (costs that are more directly related to the manufacturing of products--duh) gives the impression that more money is going into manufacturing, rather than selling and administrative costs. That seems more or less redundant but what it means for the company's statements is a false inflation of reported earnings, which is obviously unethical. As a nationally traded business, Kranbrack Corporation is held to the standards placed by the Generally Accepted Accounting Principles, and lying on your statements to look better is a big fat no-no! But more than just being blatantly unethical, holding off a butt ton of expenses until the next year will just put them even more behind for that year, a way that'll only be fixable with more smudging! It's a very vicious cycle...

    Hmm oh and one last point, while it might be okay to postpone or reduce things like end of the year advertising or travel, there are other aspects of running a business that are better kept on time, like maintenance. If a major piece of machinery breaks because they skipped a tune up or something, that will very much hurt the business more. They might also be weary of postponing orders with suppliers, because if there are already in a committed agreement with that supplier that could lead to damaged relationships or a lawsuit. I advice to them would be to tread carefully, cut back where it is ethical to do so, but know when they have to take the financial hit.

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