Sandy Carter, the newly hired controller at Riley Home Products, Inc., was disturbed by what she had discovered about the standard costs at the Home Security Division. In looking over the past several years 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. Sandy Carter ran across these letters, she asked the assistant controller, Henry Thompson, if he knew what was going on at the Home Security Division. Henry said that it was common knowledge in the company that the vice president in charge of the Home Security Division, Spencer Gilman, 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. Gilman 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 Gilman 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. Sandy Carter was concerned about these revelations and attempted to bring up the subject with the president of Riley Home Products but was told that “we all know what Gilman’s doing, but as long as he continues to turn in such good reports, don’t bother him.” When Ms. Sandy Carter asked if the board of directors was aware of the situation, the president somewhat testily replied, “Of course they are aware.”
Required:
How did Spencer Gilman probably “rig” the standard costs—are the standards set too high or too low? Explain.
Should Spencer Gilman be permitted to continue his practice of managing reported profits?
What should Sandy Carter do in this situation?
Remember, I really want to see you give this scenario some thought! This is an opportunity for you to exercise your analytical and critical thinking skills. Even if you are unsure of your answer, please post your ideas. I am less concerned with you all getting the correct answer as I am with the effort and the thought processes behind your response. Be sure to justify your assertions with specific evidence from the scenario above.