Corporate governance is the set of relationships between the board of directors, management, shareholders, auditors, and other stakeholders that determine how a company is operated. Until recently, corporations were generally free to govern themselves. However, several high-profile scandals have motivated governmental authorities to enact legislation designed to influence corporate governance. This section of the chapter examines the factors affecting corporate governance. We examine the motives and means of management corruption. Further, we introduce the mechanisms for self control including codes of ethics and internal controls. Finally, we discuss recent legislation designed to influence managerial responsibility for financial reporting.

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Management accountants are at the forefront of corporate governance. They are the guardians of the information used to report on the financial condition of their companies. The information they prepare and analyze is used by the board of directors and company executives to formulate the company’s operating strategy. Indeed, management accountants constitute the intelligence function of corporate governance. Scandals usually begin with schemes to manipulate a company’s financial reports and end when the falsification is so great it becomes obvious the reports no longer represent reality. The appropriate management of the information function is a highly effective force against corrupt governance. It is little wonder why recent legislation requires the chief financial officer along with the chief executive officer to personally certify that the company’s annual report does not contain false statements nor omit significant facts.

The Motive to Manipulate

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Explain how cost classification can be used to manipulate financial statements.

Many managers are judged on their companies’ financial statements or the companies’ stock price which is determined, in part, by the financial statements. Managers are rewarded for strong financial statements with promotions, pay raises, bonuses, and stock options. Weak financials can result in a manager being passed over for promotions, demoted, or even fired. It is little wonder that some executives are tempted to manipulate financial statements.

Marion Manufacturing Company

To illustrate implications of statement manipulation, consider the events experienced by Marion Manufacturing Company (MMC) during its first year of operations. All transactions are cash transactions.

1. MMC was started when it acquired $12,000 from issuing common stock.
2. MMC incurred $4,000 of costs to design its product and plan the manufacturing process.
3. MMC incurred specifically identifiable product costs (materials, labor, and overhead) of $8,000.
4. MMC made 1,000 units of product and sold 700 of the units for $18 each.

Exhibit 1.14 displays a set of financial statements that are prepared under the following two scenarios.

EXHIBIT 1.14	Financial Statements Under Alternative Cost Classification Scenarios
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Statement Differences

Comparing the financial statements prepared under Scenario 1 with those prepared under Scenario 2 reveals the following.

1. There are no selling and administrative expenses under Scenario 2. The design cost was treated as a product cost and placed into the Inventory account rather than being expensed.
2. Cost of goods sold is $2,800 ($4,000 design cost × .70) higher under Scenario 2.
3. Net income is $1,200 higher under Scenario 2 ($4,000 understated expense – $2,800 overstated cost of goods sold).
4. Ending inventory is $1,200 ($4,000 design cost × .30) higher under Scenario 2.

While the Scenario 2 income statement and balance sheet are overstated, cash flow is not affected by the alternative cost classifications. Regardless of how the design cost is classified, the same amount of cash was collected and paid. This explains why financial analysts consider the statement of cash flows to be a critical source of information.

Practical Implications

The financial statement differences shown in Exhibit 1.14 are timing differences. When MMC sells the remaining 300 units of inventory, the $1,200 of design and planning costs included in inventory under Scenario 2 will be expensed through cost of goods sold. In other words, once the entire inventory is sold, total expenses and retained earnings will be the same under both scenarios. Initially recording cost in an inventory account only delays eventual expense recognition. However, the temporary effects on the financial statements can influence the (1) availability of financing, (2) motivations of management, and (3) timing of income tax payments.

Availability of Financing

The willingness of creditors and investors to provide capital to a business is influenced by their expectations of the business’s future financial performance. In general, more favorable financial statements enhance a company’s ability to obtain financing from creditors or investors.

Management Motivation

Financial statement results might affect executive compensation. For example, assume that Marion Manufacturing adopted a management incentive plan that provides a bonus pool equal to 10 percent of net income. In Scenario 1, managers would receive $300 ($3,000 × 0.10). In Scenario 2, however, managers would receive $420 ($4,200 × 0.10). Do not be deceived by the small numbers used for convenience in the example. We could illustrate with millions of dollars just as well as with hundreds of dollars. Managers would clearly favor Scenario 2. In fact, managers might be tempted to misclassify costs to manipulate the content of financial statements.

Income Tax Considerations

Since income tax expense is calculated as a designated percentage of taxable income, managers seek to minimize taxes by reporting the minimum amount of taxable income. Scenario 1 in Exhibit 1.14 depicts the most favorable tax condition. In other words, with respect to taxes, managers prefer to classify costs as expenses rather than assets. The Internal Revenue Service is responsible for enforcing the proper classification of costs. Disagreements between the Internal Revenue Service and taxpayers are ultimately settled in federal courts.

Problem  1-23A, 1-23B