Stacy Cummins, the newly hired controller at Merced Home Products, Inc., was disturbed by what she haddiscovered about the standard costs at the Home Security Division. In looking over the past several yearsof quarterly income statements at the Home Security Division, she noticed that the first-quarter profits were always poor, the second-quarter profits were slightly better, the third- quarter profits were againslightly better, and the fourth quarter always ended with a spectacular performance in which the HomeSecurity Division managed to meet or exceed its target profit for the year. She also was concerned to findletters from the company’s external auditors to top management warning about an unusual use of standardcosts at the Home Security Division.When Ms. Cummins ran across these letters, she asked the assistant controller, Gary Farber, if he knewwhat was going on at the Home Security Division. Gary said that it was common knowledge in the companythat the vice president in charge of the Home Security Division, Preston Lansing, had rigged the standards athis division in order to produce the same quarterly income pattern every year. According to company policy,variances are taken directly to the income statement as an adjustment to cost of goods sold.Favorable variances have the effect of increasing net operating income, and unfavorable varianceshave the effect of decreasing net operating income. Lansing had rigged the standards so that there werealways large favorable variances. Company policy was a little vague about when these variances have tobe reported on the divisional income statements. While the intent was clearly to recognize variances on theincome statement in the period in which they arise, nothing in the company’s accounting manuals actuallyexplicitly required this. So for many years Lansing had followed a practice of saving up the favorable variances and using them to create a nice smooth pattern of growing profits in the first three quarters, followedby a big “Christmas present” of an extremely good fourth quarter. (Financial reporting regulations forbidcarrying variances forward from one year to the next on the annual audited financial statements, so all ofthe variances must appear on the divisional income statement by the end of the year.)Ms. Cummins was concerned about these revelations and attempted to bring up the subject with thepresident of Merced Home Products but was told that “we all know what Lansing’s doing, but as long as hecontinues to turn in such good reports, don’t bother him.” When Ms. Cummins asked if the board of directors was aware of the situation, the president somewhat testily replied, “Of course they are aware.”Required:1. How did Preston Lansing probably “rig” the standard costs—are the standards set too high or too low?Explain.2. Should Preston Lansing be permitted to continue his practice of managing reported profits?3. What should Stacy Cummins do in this situation?
Stacy Cummins, the newly hired controller at Merced Home Products, Inc., was disturbed by what she had
discovered about the
of quarterly income statements at the Home Security Division, she noticed that the first-quarter profits were always poor, the second-quarter profits were slightly better, the third- quarter profits were again
slightly better, and the fourth quarter always ended with a spectacular performance in which the Home
Security Division managed to meet or exceed its target profit for the year. She also was concerned to find
letters from the company’s external auditors to top management warning about an unusual use of standard
costs at the Home Security Division.
When Ms. Cummins ran across these letters, she asked the assistant controller, Gary Farber, if he knew
what was going on at the Home Security Division. Gary said that it was common knowledge in the company
that the vice president in charge of the Home Security Division, Preston Lansing, had rigged the standards at
his division in order to produce the same quarterly income pattern every year. According to company policy,
variances are taken directly to the income statement as an adjustment to cost of goods sold.
Favorable variances have the effect of increasing net operating income, and unfavorable variances
have the effect of decreasing net operating income. Lansing had rigged the standards so that there were
always large favorable variances. Company policy was a little vague about when these variances have to
be reported on the divisional income statements. While the intent was clearly to recognize variances on the
income statement in the period in which they arise, nothing in the company’s accounting manuals actually
explicitly required this. So for many years Lansing had followed a practice of saving up the favorable variances and using them to create a nice smooth pattern of growing profits in the first three quarters, followed
by a big “Christmas present” of an extremely good fourth quarter. (Financial reporting regulations forbid
carrying variances forward from one year to the next on the annual audited financial statements, so all of
the variances must appear on the divisional income statement by the end of the year.)
Ms. Cummins was concerned about these revelations and attempted to bring up the subject with the
president of Merced Home Products but was told that “we all know what Lansing’s doing, but as long as he
continues to turn in such good reports, don’t bother him.” When Ms. Cummins asked if the board of directors was aware of the situation, the president somewhat testily replied, “Of course they are aware.”
Required:
1. How did Preston Lansing probably “rig” the standard costs—are the standards set too high or too low?
Explain.
2. Should Preston Lansing be permitted to continue his practice of managing reported profits?
3. What should Stacy Cummins do in this situation?
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