Reference no: EM13902793

Management decisions and external financial reports. ‘‘Squeezing oranges in your idle time is not a by-product,'' said the Big Four partner in charge of the audit of Star Company disapprovingly. ‘‘But,'' replied the president of Star, ‘‘squeezing oranges is not our usual business, and your accounting plan will make us show a substantial decline in income. We all know that our decision this year to squeeze oranges was a good one that is paying off handsomely.''

The argument concerned the accounting for income during the year 2002 by Star Company.

Background: The Alcoholic Control Board (ACB) of Georgia, a state not known for its production of grapes and wines, wanted to encourage the production of wine within the state. The executives of Star Company formed their company in 1995 in response to the encouragement of the ACB. The production process for wine involves aging the product. The company commenced production in 1996 but did not sell its first batch of wine until 1998. At the start of 1996, Star made a cash investment of $4,400,000 in grape-pressing equipment and a facility to house that equipment. The ACB has promised to buy Star Company's output for 10 years, starting with the first batch in 1998. Star Company decided to account for its operations by including in the cost of the wine all depreciation on the grape-pressing equipment and on the facility to house it. The firm judged the economic life of the equipment to be 10 years, the life of the contract with the ACB. Star Company reported general and administrative expenses of $100,000 per year in external financial reports for both 1996 and 1997.

Star Company's contract with the ACB promised payments of $1.8 million per year. The direct costs of labor and materials for each year's batch of wine were $130,000 each year. Accounting charges depreciation on a straight-line basis over a 10-year life. The income taxes were 40 percent of pretax income.

The wine sales began in 1998, and operations proceeded as planned. The income statements for the years 1998 through 2001 appear in Exhibit 12.5.

Management of Star Company was delighted with the offer in 2001 from a manufacturer of frozen orange juice to put its idle capacity to work. It contracted with the manufacturer to perform the services. At the end of 2002, it compiled the income statement shown in the ‘‘Management's View'' column in Exhibit 12.5.

The Accounting Issue: Management of Star Company suggested that the revenues from squeezing oranges are an incremental by-product of owning the wine-making machinery. The wine-making process was undertaken on its own merits and has paid off according to schedule. The revenues from squeezing oranges are a by-product of the main purpose of the business. Ordinarily, the accounting for by-products assigns to them costs equal to their net realizable value; that is, accounting assigns costs in exactly the amount that will make the sale of the by-products show neither gain nor loss. In this case, because the incremental revenue of squeezing oranges was $100,000, Star Company assigned $100,000 of the overhead to this process, reducing from $440,000 to $340,000 the overhead assigned to the main product. This will make the main product appear more profitable when it is sold.

Management of Star Company was aware that its income for 2002 would appear no different from that of the preceding year. Management knew that the benefits from squeezing oranges began to occur in 2002 but allowed the benefits to appear on the financial statements later.

The Big Four auditor who saw management's proposed income statement disapproved.

The partner in charge of the audit spoke as quoted at the beginning of this case.

The auditor argued that squeezing oranges under these circumstances was not a by- product and that by-product accounting was inappropriate. Star Company must allocate the overhead costs between the two processes of grape pressing and orange squeezing according to some reasonable basis. The most reasonable basis, the auditor thought, was the time devoted to each of the processes. Because grape pressing used about 20 percent of the year, whereas orange squeezing used 80 percent of the year, the auditor assigned $352,000, or 80 percent, of the overhead costs to orange squeezing and $88,000, or 20 percent, to the wine production. Exhibit 12.5 shows the auditor's income statement in the ‘‘Auditor's View'' column.

This statement upset the president of Star Company. Reported net income in 2002 is down almost 30 percent from 2001, yet things have improved. The president fears the reaction of the board of directors and the shareholders. The president wonders what has happened and what to do.

a. Assuming that the Star Company faces an after-tax cost of capital of 10 percent, did the company in fact make a good decision in 1995 to enter into an agreement with the state to produce wine? Explain.

b. Did the company in fact make a good decision in 2001 to enter into the agreement with the manufacturer of frozen orange juice?

c. Using management's view of the proper accounting practices, construct financial statements for the years 2003, 2004, and 2005, assuming that events occur as planned and in the same way as in 2002. Generalize these statements to later years.

d. Are management's statements correct given its interpretation of by-product accounting? If not, construct an income statement for 2002 that is consistent with by-product accounting.

e. Is management correct in its interpretation that the orange juice is a by-product?

f. Using the auditor's view of the situation and assuming the same facts as in part c., construct income statements for the years 2003, 2004, and 2005. Generalize these statements to later years.

g. Assuming that the auditor is right, what may management of Star Company do to solve its problem?

Text Book: Fundamentals of Cost Accounting 2nd Edition.