Accounting principles, illusory profits and inventory manipulation

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What accounting concept underlies the requirement of absorption costing for external financial reporting purposes?

The matching principle underlies the requirement of absorption costing for external financial reporting purposes "The matching principle is based on the accrual concept and states that costs incurred to generate a particular revenue should be recognized as expenses in the same period that the revenue is recongized"(Garrison, Noreen, Brewer, Chesley, Carroll, Webb, Libby, 2012, page34).Absorption costs include direct material, direct labour, and fixed and variable manufactoring overhead, which is almost all total cost when products are produced. When products are sold, accoounting can accuratly states the production cost of the sold product. Variable cost does not include fixed manufactoring cost, and it does not cover all production costs. Variable cost only can be used internal for management, but absorbtion costs could be used for both external financial report and internal management purposes.

Explain the concept of “phantom” or “illusory profits”. Could a firm with sales below the break-even point report profits?

Illusory profits is "the profit reported using historical costs required by US GAAP, and the profit computed using replacement costs. Illusory profit is greatest during periods of rising costs at companies with significant amounts of inventory and plant assets"(Averkamp,2014, what is illusory profit). Firm uses first in first out method to record the costs, and they choose to change to weighted-average cost method, this would increase profit. For example, a firm produce 10 inventories and each cost \$20, 11 inventories at \$15 each, and 12 units at \$10 each, and firm sold 25 inventories. When using FIFO method the firm's cost of good sold is \$20*10 + \$15*11 + \$10*4 = \$405. When changes to weighted average method, the total costs is \$20*10 + \$15*11 + \$20*12 = \$485, each unit costs \$485/33 = \$14.70, and cost of good sold is \$14.70*25 = 367.5. The costs decrease even firms sold same amount of inventories. Since the cost of good sold decrease, when using FIFO method the sales is below break-even point, but by using weight-average method, the firm gets more profit, so there is a change that firm could have profit even when sales below the break-even point.

Find an article from the business press that reports on a company that has boosted reported profits by manipulating inventory. In your own words, describe how the company did this and what the outcome was.

De Angelis was know by 'The Great Salad Oil Swindle', fifty years ago, he first produced uninspected meat to school, and in order to gain more profit, Angelis produced over 2 million pounds of mean and sold them to school and overcharge government, he went bankrupt form this. But he did not learn lesson from this, instead, he start a vegetable oil company. He signed a contract with US government and he sold exceed amount of vegetable oil to poor countries and earned a lot of profit from this. He also claimed to produce a large amount of vegetable oil, "De Angelis claimed 1.8 Â­billion pounds of soybean oil, but had only 110 Â­million—the swindle raised at least \$180 million from investors"(Malone, 2012, New York Magazine). TO fake his inventroies, he filled tanks with only a small amount of oil with rest of the fluid being water, and since oil is lighter than water, his creditors saw the tanks full with vegetable oil. He also built a underground pipe between tanks, he left many tanks empty, and when cretiors checked tanks he just filled up tanks that they were checking. When he could not open enough marget to sell all his oil, eventually, his creditor found out and "De Angelis received a seven-year jail term"(Taylor, 2013, Business insider).

Reference

Garrision, Ray H., Noreen, Eric W., Brewer Peter C., Carroll, Ray F., Webb, Alan, Libby, Theresa (2012). Managerial Accounting (Ninth Canadian Edition). Ontario, Whitby: McGraw-Hill Ryerson.

Averkamp, Harold. Accounting Coach. What is illusory profit. Retrieved from: http://www.accountingcoach.com/blog/what-is-illusory-profit [last accessed March 25, 2014]

1. What accounting concept underlies the requirement of absorption costing for external financial reporting purposes?

The matching principle would underlie the requirement of absorption costing for external report. The meaning of absorption costing is "A costing method that includes all manufacturing costs-direct materials, direct labor, and both variable and fixed overhead-as part of the cost of a finished unit of product; synonymous with full costing." Garrison, Noreen, Brewer, Chesley, Carroll, Webb, Libby, 2012, page 70). As the result, the absorption costing has to take the expenses and the revenues at the same periods since this costing way absorbed all costs at one period. Therefore, the absorption costing would required to follow Matching principle which is "based on the accrual concept and states that cost incurred to generate a particular revenue should be recognized as expenses in the same period that the revenue is recognized".( Garrison et al, 2012, page 34) Thus, absorption costing could use for external report. However, the variable costing does not have to follow matching result, as it can only use for internal interpreting.

2. Explain the concept of “phantom” or “illusory profits”. Could a firm with sales below the break-even point report profits? Explain.

Phantom profits or illusory profits are used "in the context of inventory (but can also pertain to depreciation) during periods of rising costs." (Averkamp, 2014, what are phantom profits) Illusory profits is the differences between " the profit reported using historical cost—as required by generally accepted accounting principles (GAAP)—and the profit that would have been reported if replacement cost had been used. " (Averkamp, 2014, what are phantom profits) In other words, some firms would like to boost their costs by using different costing way such as switching FIFO to Weighted average to minimize their profit and pay less tax."GAAP doesn't allow the use of replacement cost since that violates the (historical) cost principle." (Averkamp, 2014, what are phantom profits)

Firms could also report profits if they switch the costing way even the sales are below the break-even point. For example, Firm A's historical costing way is First In First Out. And also, Firm A bought the inventory first is 5 dollars for 5 units. Then it bought 3 dollars for another 5 units. For this period, Firm A sold 6 units. For usual, the cost of goods sold would be 5*5+1*3=\$28. However, Firm A wants to decrease the cost in this period. Cost of goods sold would be also the part of the costs. As the result, Firm A decides to switch to weighted average try to lower the cost. Therefore, each unit will cost \$4(3*5+5*5=40, 40/10=4). The cost of goods sold would become \$24. The cost would lower just because firm A switching the historical cost to replacement cost. In this way, firms could still report there is profit even though they did not meet the break-even point since having a lower cost by using replacement cost way.

3. Find an article from the business press that reports on a company that has boosted reported profits by manipulating inventory. In your own words, describe how the company did this and what the outcome was.

Crazy Eddie would be a famous case for the firm boosted the profits by manipulating inventory. In 1970s, a businessman called Eddie Antar who was well-known for selling electronics in Brooklyn, New York. At that time, there is a loud voice showing Antar was "success" which is "Crazy Eddie will bead any price you find". However, in 1989, Eddie Antar was accused by "Cooking the books". To keep the upward trend in the stock price, he ask his subordinate to over count the inventory by \$2 million. As the result, the gross profit would also be overstated by \$2 million. In the following years, he overstated inventory \$9 million by "preparing count sheets for inventory that did not exist and by including in inventory consigned merchandize and goods being returned to suppliers"(WELLS, 2014 How to Spot Phantom Inventory). He did not stop overstating the inventory until the firm was purchased by his competitor. The buyer eventually found out there are over \$80 million inventory was fake. In 1994, Antar consequently was sentenced to eight years in prison and also have to pay over \$150 million in fines. (WELLS, 2014 How to Spot Phantom Inventory)

Reference:

Garrision, Ray H., Noreen, Eric W., Brewer Peter C., Carroll, Ray F., Webb, Alan, Libby, Theresa (2012). Managerial Accounting (Ninth Canadian Edition). Ontario, Whitby: McGraw-Hill Ryerson.

Averkamp, H. (2014). What are phantom profits? | AccoutingCoach. [online] Retrieved from: http://www.accountingcoach.com/blog/phantom-profit-illusory-proft [Accessed: 26 Mar 2014].

WELLS, J. T. (2014). Ghost Goods: How to Spot Phantom Inventory. [e-book] p. page 7. Available through: http://people.wallawalla.edu/

http://people.wallawalla.edu/~bruce.toews/a322/Assignments/322 9d Inventory Articles.pdf [Accessed: 26 Mar 2014].