A. If Patty wants to show the bank the maximum profit over the previous 2-year period, which costing method should she present?

In this case the issue is not what type of financial statements Patty wants to show to the bank it is what she has to show to the bank. It is important to understand the difference between these two methods. A manufacturer has two general ways to account for fixed manufacturing costs: variable costing and absorption costing also know as full costing (this method is mandatory by GAAP). Under variable costing you do not include fixed manufacturing costs in the calculation of the cost of each item produced. Under full costing you allocate a portion of those fixed cost to each item. Variable costing has distinct advantage for internal planning and assessment, because variable costing provides a more accurate picture of the cash flow, which is a critical for small manufactures operating with a tighter margin. Also costing method provides all the data necessary for break - even analysis, a key tool in determining how much the company must sell at certain price before it shows a manufacturing profit. Variable costing has great advantages in business the variable costing data are quite useful in avoiding incorrect decisions about product discontinuation and so on.
Having both sets of profit figures enables the executive to form judgments with much greater facility than if only profit figure were available; it also facilitates responsibility accounting by making it possible to have information by organizational levels. This dual approach provides the additional information that management needs for making decisions and still follows generally accepted accounting principles. A system combining variable costing and absorption costing with standard costs and flexible budgets provides more effective cost control. But the use of this report is strict only for internal analysis and cannot be used it for external financial reports.

For this company the variable costing shows a better outlook of the organization. The reason is because variable costing method clearly separates the cost that rise in tandem with production from those that remain constant, treats all fixed overhead cost as period cost, this includes a reasonable portion of production overhead incurred in connection with manufacturing the inventory, and that affecting the operating income results. But the variable costing financial statement reports is only for internal purposes on internal documents inside the company. Patty has to provide to the bank the Full Costing Income statements.

B. But, the bank requires that all financial statements conform to Generally Accepted Accounting Principles (GAAP). Based on that requirement, which costing method should she present?

Generally accepted accounting principles (GAAP), require the use of full costing in financial statements prepared for outsider observers, such a potential investor for the business and for a bank that the company is approaching for a loan.

The GAAP standard setters believe that full costing better upholds the matching principle, which requires that expenses be reported in the same period as the revenue is generated by those expenses. Since fixed manufacturing costs contribute revenue only when manufactured goods are actually sold for revenue.
C. The bank has delivered a memo in preparation for the meeting to negotiate the Credit Line; the memo states that they will expect a significant Net Income. Based on your responses to parts A and B, what are the legal and ethical issues facing Stacy Lynn?

For Stacy Lynn Inc. The ethical issue is the honesty in what model of reporting the company is willing to use to show the better outlook of the business. For instance variable costing profits are higher than those under full costing method. Variable costing will not show overhead which means it does not show a complete picture. This appears to be a legal issue. Full costing accounting must be used because Banks follow the regulations of the federal government and follow GAAP rules as FASB has not recognized variable as a generally accepted inventory valuation method because of its belief that fixed production costs are as much a part of manufacturing the product, as are variable costs. In addition, variable costing violates the cost attaching and matching principal. Likewise, the IRS does not recognize variable costing as an acceptable inventory method. The Tax Reform Act (TRA) of 1986 changed inventory accounting for income tax purposes by requiring the capitalization of additional costs to inventory.

This will tell the bank whether Patty should receive a high line of credit or low or none according to the company profit and credibility. and


An the professor asked me this Nagibe, is it ethical for a business owner to overlook sound business decisions just because the the full costing method is the only method that is accepted by GAAP? I am reminded that owners are profit driven and they are also driven by trying to impact an overall competitive advantage in the marketplace.