Task 1 (10 marks) (approximately 500 words) Blake Romney became Chief Executive

Question

Task 1 (10 marks) (approximately 500 words)

Blake Romney became Chief Executive Officer of Peters Inc. two years ago. At the time, the

company was reporting lagging profits, and Blake was brought in to “stir things up.” The company

has three divisions, electronics, fibre optics, and plumbing supplies. Blake has no interest in

plumbing supplies, and one of the first things he did was to put pressure on his accountants to

reallocate some of the company’s fixed costs away from the other two divisions to the plumbing

division. This had the effect of causing the plumbing division to report losses during the last two

years; in the past it had always reported low, but acceptable, net income.

Blake felt that this reallocation would shine a favourable light on him in front of the board of directors

because it meant that the electronics and fibre optics divisions would look like they were improving.

Given that these are “businesses of the future,” he believed that the stock market would react

favourably to these increases, while not penalizing the poor results of the plumbing division. Without

this shift in the allocation of fixed costs, the profits of the electronics and fibre optics divisions would

not have improved.

But now the board of directors has suggested that the plumbing division be closed because it is

reporting losses. This would mean that nearly 500 employees, many of whom have worked for

Peters their whole lives, would lose their jobs.

Required

1. If a division is reporting losses, does that necessarily mean that it should be closed?

2. Was the reallocation of fixed costs across divisions unethical?

3. What should Blake do?

Explanation / Answer

1.Discontinuing Operation 3. A discontinuing operation is a component of an enterprise: (a) that the enterprise, pursuant to a single plan, is: (i) disposing of substantially in its entirety, such as by selling the component in a single transaction or by demerger or spin-off of ownership of the component to the enterprise's shareholders; or (ii) disposing of piecemeal, such as by selling off the component's assets and settling its liabilities individually; or (iii) terminating through abandonment; and (b) that represents a separate major line of business or geographical area of operations; and (c) that can be distinguished operationally and for financial reporting purposes.

If an enterprise sells a component substantially in its entirety, the result can be a net gain or net loss. For such a discontinuance, a binding sale agreement is entered into on a specific date, although the actual transfer of possession and control of the discontinuing operation may occur at a later date. Also, payments to the seller may occur at the time of the agreement, at the time of the transfer, or over an extended future period. 6. Instead of disposing of a component substantially in its entirety, an enterprise may discontinue and dispose of the component by selling its assets and settling its liabilities piecemeal (individually or in small groups). For piecemeal disposals, while the overall result may be a net gain or a net loss, the sale of an individual asset or settlement of an individual liability may have the opposite effect. Moreover, there is no specific date at which an overall binding sale agreement is entered into. Rather, the sales of assets and settlements of liabilities may occur over a period of months or perhaps even longer. Thus, disposal of a component may be in progress at the end of a financial reporting period. To qualify as a discontinuing operation, the disposal must be pursuant to a single co-ordinated plan. 7. An enterprise may terminate an operation by abandonment without substantial sales of assets. An abandoned operation would be a discontinuingoperation if it satisfies the criteria in the definition. However, changing the scope of an operation or the manner in which it is conducted is not an abandonment because that operation, although changed, is continuing. 8. Business enterprises frequently close facilities, abandon products or even product lines, and change the size of their work force in response to market forces. While those kinds of terminations generally are not, in themselves, discontinuing operations as that term is defined in paragraph 3 of this Standard, they can occur in connection with a discontinuing operation. 9. Examples of activities that do not necessarily satisfy criterion (a) of paragraph 3, but that might do so in combination with other circumstances, include: (a) gradual or evolutionary phasing out of a product line or class of service; (b) discontinuing, even if relatively abruptly, several products within an ongoing line of business; (c) shifting of some production or marketing activities for a particular line of business from one location to another; and (d) closing of a facility to achieve productivity improvements or other cost savings. An example in relation to consolidated financial statements is selling a subsidiary whose activities are similar to those of the parent or other subsidiaries. 10. A reportable business segment or geographical segment as defined in Accounting Standard (AS) 17, Segment Reporting, would normally satisfy criterion (b) of the definition of a discontinuing operation (paragraph 3), that is, it would represent a separate major line of business or geographical area of operations. A part of such a segment may also satisfy criterion (b) of the definition. For an enterprise that operates in a single business or geographical segment and therefore does not report segment information, a major product or service line may also satisfy the criteria of the definition. 11. A component can be distinguished operationally and for financial reporting purposes - criterion (c) of the definition of a discontinuing operation (paragraph 3) - if all the following conditions are met: Discontinuing Operations 385 (a) the operating assets and liabilities of the component can be directly attributed to it; (b) its revenue can be directly attributed to it; (c) at least a majority of its operating expenses can be directly attributed to it. 12. Assets, liabilities, revenue, and expenses are directly attributable to a component if they would be eliminated when the component is sold, abandoned or otherwise disposed of. If debt is attributable to a component, the related interest and other financing costs are similarly attributed to it. 13. Discontinuing operations, as defined in this Standard, are expected to occur relatively infrequently. All infrequently occurring events do not necessarily qualify as discontinuing operations. Infrequently occurring events that do not qualify as discontinuing operations may result in items of income or expense that require separate disclosure pursuant to Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies, because their size, nature, or incidence make them relevant to explain the performance of the enterprise for the period. 14. The fact that a disposal of a component of an enterprise is classified as a discontinuing operation under this Standard does not, in itself, bring into question the enterprise's ability to continue as a going concern.

2.An audit might point out that the fixed costs associated exclusively with one division might be properly noted in that division's accounts.

For example, if the corporation made automobile axles and artisan bread, for example, the fixed costs associated with bread-making would require significant explanation of they appeared on the financial reports for axles. However, creative accounting can work miracles.

The crux of your question might be 'reallocation'. Your corporate ethics officer can answer your question specifically.

And often, ethics and the law are not the same.

3. Blake should ask for some more time to prove the worth of that sector.

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