The University of Illinois Executive MBA
Case Summaries
Accy 401, EMBA; Fall 2000
Accounting courses are usually separated into five general categories. Two, taxes and
auditing, are usually quite technical and often focus on CPA preparation. The other three
categories are more general:
1. Financial accounting deals almost strictly with financial statement preparation. It
focuses on pronouncements issued by the Financial Accounting Standards Board
(FASB) and the SEC, and on accounting concepts such as materiality, matching
revenues and expenses, relevance, and consistency. It also considers highly technical
details about consolidated financial statements, leases, pensions, income taxes, and
inventory valuation methods that are often found on the CPA exam.
2. Financial accounting from a management perspective covers many of the same
topics as financial accounting but it does so from the view of a manager using
financial accounting information to help make decisions or to report an organization’s
performance to others. This is the typical focus of an MBA financial accounting
course, or a financial accounting course in a non-degreed program for executives. It is
the primary focus of Accy 401, EMBA.
3. Cost and managerial accounting deals almost exclusively with accounting as a tool
to help manage and understand a business. These courses focus on areas such as fixed
and variable costs, how costs behave over time (e.g., the learning curve), cost systems,
and ways to allocate fixed costs to products or product lines.
These courses also consider how cost information influences organizations. For
example, firms with multiple divisions often sell products between divisions. The
price one division charges another, the transfer price, has a major effect on how each
division operates. Transfer prices are a common source of friction between divisions.
There is no ideal transfer pricing system, but some are far worse than others.
This course deals with financial accounting from a management perspective; your next
accounting course deals almost exclusively with cost and managerial accounting. Many of
the financial accounting cases, however, are broad enough to cover more than one aspect of
cost or managerial accounting. The following case summaries separate the topics each case
covers into the above three categories
.
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Verona Springs Mineral Water
Financial Accounting:
This case demonstrated the basics of double entry bookkeeping. That topic includes
journal entries and how journal entries are used to create a ledger of the firm’s accounts. The
case also demonstrates how the two basic financial statements, the income statement and
balance sheet, are prepared from the ledger. It then covered how the statement of cash flows
is prepared from the balance sheet.
The case covered the idea that costs can either be capitalized or expensed. It also
covered the idea that most capitalized costs are eventually expensed, with land being the
typical exception). It also introduced the idea that by expensing and item rather than
capitalizing the item, a firm lowers its net income in the current period. By capitalizing the
item, a firm would show higher net income in the current period, but lower income in each of
the future periods when the capitalized expense is depreciated (fixed assets), amortized
(intangible assets), or depleted (mineral assets such as oil or gold).
When considering whether to capitalize or expense an item, we considered two
accounting concepts: the concept of matching revenues with expenses and the concept of
materiality. For example, the well was clearly an asset that would have future value, but its
value was low enough that it was reasonable to expense so as to avoid record keeping costs.
Financial Accounting from a management perspective:
The case is primarily a technical introduction to financial accounting, but it did
introduce the idea that the user should look at accounting numbers with some skepticism. For
example, the income statement did not include any cost for setting up the company, no costs
for utilities, and no cost for the owner’s salary. In addition, the income statement included
interest expense for two months expense even though the firm had only operated its
equipment for one month. In addition, the income statement included the cost of drilling a
well that would last for ten years.
Cost accounting and managerial accounting:
The case introduced fixed and variable costs. For example, depreciation expense and
interest expense are fixed costs that only change if there is a major change in production
volume. Thus, if the firm doubled its sales its income would more than double. That is,
revenue would double, variable costs such as supplies, labor, and shipping would double, but
fixed costs would remain unchanged.
This case introduced the idea of account numbers that can be used to separate
revenues and costs into great detail without much work on the part of accountants, so long as
a well-designed system is in place. That is, a company may record its travel and
entertainment expenses in account number 2118. Suppose the expense is incurred at the
company’s speed switch subsidiary (subsidiary 18), at the Dallas office of that subsidiary
(location 05), by a salesperson whose code is 16. The company might debit account 18-1016-2118. With a well-designed accounting system, the company could then determine travel
and entertainment expenses by individual, by location, by subsidiary, or for the entire
company.
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Chemalite
Financial Accounting:
This case again demonstrated the basics of double entry bookkeeping and how
financial statements are prepared from journal entries. It also introduced the idea of research
and development costs. Since 1971 the FASB has required that companies expense R&D
costs. As with Verona Springs,
This case also briefly introduces revenue recognition. Chemalite has a firm order in
hand but has not yet shipped the goods and wonders whether to recognize revenue. We
discussed the idea that a firm must have completed the process by which it adds value to it
product, which usually, but not always, includes shipping the good to a customer or
completing the service. It must also be able to determine the amount of the sale, which
includes reasonable assurance that the customer has the ability and willingness to pay for the
product.
Financial Accounting from a management perspective:
This case focused on the statement of cash flows, since one of the investors was
concerned about the large decrease in cash. This case also demonstrates that financial
statement should consider the three financial statements as an integrated package of
information. Ideally, the income statement gives information on a company’s economic
performance during a period and the balance sheet provides information on a company’s
financial viability in the short and the long run
The statement of cash flows supplements the first two statements. For example, it
demonstrates whether the firm is generating a positive or negative cash flow from operations.
It also shows how much cash the firm is investing and how much it is generating from
financing. The user can then consider what might change and then estimate what the
statement of cash flows will look like in the future (we will consider this topic the first class
after the mid-term).
Cost accounting and managerial accounting:
Similar to Verona Springs.
Martha Stewart (briefly)
Financial Accounting:
We compared Martha Stewart’s financial statements to the basic ones we prepared for
Verona Springs and Chemalite. Although Martha Stewart’s financial statements are more
complex, they are prepared exactly as we prepared financial statement for these introductory
cases.
Financial Accounting from a management perspective:
Martha Stewart is a profitable firm with little concern about financial viability. The
firm has positive cash flows from operations, has little debt, and should have no short-term or
longer-term problems with liquidity.
Cost accounting and managerial accounting:
None.
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Ventro; formerly Chemdex (briefly)
Financial Accounting:
We introduced one of the revenue recognition problems or Internet companies. That
is, Chemdex is an on-line store for specialty chemicals. Chemdex lists goods from many
different suppliers; Chemdex customers can then select the supplier and product and place an
order through Chemdex. Suppose a Chemdex customer pays $100 for an item that the
supplier sells to Chemdex for $95. Should Chemdex report revenue of $5, or revenue of $100
less $95 cost of goods sold?
The technical accounting rule is that if Chemdex takes possession of the goods, and
bears the risk that the customer will not pay, it can record revenues of $100. However, the
SEC refers to Chemdex’ practice as “microsecond” possession. That is, Chemdex seems to
take possession legal form, but not in substance.
Financial Accounting from a management perspective:
The primary issue with revenue recognition is that Chemdex reports the higher
revenue number so as to appear to be a more substantial firm. There are several financial
analysis issues in the case. One has to do with Chemdex’ profit model. Will Chemdex ever
be profitable given its high fixed cost structure, combined with the small profit or commission
it makes on each transaction?
Another financial analysis issue concerns cash flows. Chemdex has a reasonable
amount of cash but it is rapidly burning cash. There seems to be little indication that
Chemdex will become cash flow positive in the short term or even the intermediate term.
Cost accounting and managerial accounting:
None.
Monterrey Manufacturing Company
Financial Accounting:
This case introduced the idea that material costs are capitalized as a part of inventory
cost. It also introduced the idea that direct labor and indirect labor and overhead costs are
also be capitalized as a part of inventory cost.
Financial Accounting from a management perspective:
We briefly discussed which costs should be capitalized. That is, if a firm capitalizes
more indirect costs as a part of inventory, it will report higher net income. We introduced the
idea that in a few instances companies must report the same costs for financial reporting as
they do for income taxes. In most cases, however companies can use different methods for
financial reporting and income tax reporting.
Cost accounting and managerial accounting:
We briefly discussed how companies compute the cost of items they produce (parts,
subassemblies, and finished units), and the problems involved in computing product costs.
For example, we considered how companies might accumulate product costs for products
made in a job-order production process, such as ships or machine tools. In those cases, firms
simply record material, and direct labor by job, and then allocate overhead costs to each job
based on factors such as direct labor costs or machine hours.
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For complex assembly processes such as autos, cost accounting is far more difficult.
We discussed how a finished unit is produced from subassemblies and parts, and how the
subassemblies used in final production themselves are produced from parts or subassemblies.
For a complex product, the number of steps whereby subassemblies are produced from
subassemblies may be quite large. That makes it difficult to account for costs and even more
difficult to separate costs into material, labor, and overhead components. However, welldesigned cost systems have been able to do that since the mid-1960s.
Precision Worldwide
Financial Accounting:
None.
Financial Accounting from a management perspective:
None.
Cost accounting and managerial accounting:
This case involves steel rings that can now be made of plastic. The plastic parts will
be less expensive and will last longer. The company has a supply of steel rings ready for sale,
together with a supply of steel that has no other use than to produce steel rings.
This case introduces the concepts of allocated costs, contribution margin, and
opportunity cost. The case introduces a number of layers of sophistication when applying the
concept of contribution margin. The first point is that the cost of the steel should be
considered zero, since it is a sunk cost with no other use. The second issue is that allocated
fixed costs are irrelevant in the short run. That is, regardless of whether the company
produces steel or plastic rings, the fixed overhead costs will not change.
The next issue is the direct labor needed to convert steel into rings. Because of the
company’s policy, the steel rings can be produced using low cost labor, which lowers the
opportunity cost of producing the steel rings to less than the cost of the plastic rings, assuming
the material cost of the steel rings is zero.
The next issue is the opportunity cost of the steel rings is zero, since they are complete
with no other use. That is the out-of-pocket cost to the company for selling the completed
steel rings is zero.
Once we have computed the opportunity cost to produce steel rings, and the
opportunity cost of the already completed steel rings (zero), we are faced with a final
opportunity-cost issue. That is, what will customers pay for steel rings given that they have a
two-month life and plastic rings have at least an eight-month life? If customers are willing to
pay four times as much for plastic rings, then even if we assume our steel rings have a cost of
zero, we are better off selling plastic rings because our contribution per month is higher for
plastic rings than for steel rings.
Precision Worldwide is thinking about selling plastic rings in France and selling steel
rings elsewhere until customers learn they are inferior. This introduces the idea that pricing
policy and product policy can help the company in the short run but harm it in the long run.
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Hilton Manufacturing Company
Financial Accounting:
None.
Financial Accounting from a management perspective:
None.
Cost accounting and managerial accounting:
This case expands on the idea of contribution margin by looking at how costs are
allocated to different products. One of the company’s three products is loosing money and
another is almost at breakeven.
This is one of the most common problems in business. When we look at the
contribution margin of the three products (i.e., we ignore allocated fixed costs), it is not at all
clear which product is the most attractive. That is, one product has the greatest contribution
per unit sold, another has the greatest contribution per sales dollar, and the third has the
greatest contribution per unit of manufacturing capacity.
Fixed overhead costs are an irresolvable problem. Companies must cover all of their
fixed costs in the long run, or they will be out of business. However, in the short run, it may
be very attractive to sell products at any price above variable costs because that will at least
provide some contribution to covering fixed costs.
We discussed how companies with high fixed costs are most likely to face large
swings in their selling price. For example, the out-of-pocket cost for an airline to fly one
additional passenger is quite low. In the past, it was not uncommon for an airline to cut the
cost of a New York to Los Angeles flight from $600 to $300, with other airlines following.
On the other hand, a car dealer has a relatively high out-of-pocket cost relative to
selling price. It is inconceivable that a Buick dealer would cut the selling price of a Buick
LeSabre from $30,000 to $15,000.
Laurinburg Precision Engineering
Financial Accounting:
This case shows an instance where accountants do not strictly rely on the cost concept.
That is, a firm may issue zero-coupon bonds at a fraction of the amount at which they will be
redeemed. The firm initially records the bonds at the amount received, but each year (or
month) the firm increases the liability by recording interest expense.
Similarly, if a company purchased zero-coupon bonds, it would initially record the
asset at the amount paid. It would then gradually record interest income and increase the
amount of the asset.
Financial Accounting from a management perspective:
This case introduced the basics of discounted cash flows, which will be used
throughout the MBA program, and throughout your career.
Cost accounting and managerial accounting:
None.
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Microsoft Financial Reporting Strategy
Financial Accounting:
This case introduces two controversial financial accounting topics that arise in the
software industry: revenue recognition and the capitalization of software development costs.
Financial Accounting from a management perspective:
With respect to revenue recognition, Microsoft argues that it will provide
additional services throughout the life of the software it is selling, so it should defer revenue
recognition on a part of the sale price.
With respect to software development costs, accounting rules give companies wide
latitude as to what they can capitalize. Microsoft chooses to expense almost all software
development costs, so for both revenue recognition and capitalization, Microsoft appears to
choose very conservative accounting policies. However, Microsoft also changed its revenue
recognition policies to increase revenues, presumably during a period when revenue growth
was less than expected.
Sometimes financial statement users think of conservative accounting policies as less
controversial than aggressively liberal accounting policies. However, this case illustrates that
either accounting policy makes it more difficult to compare firms with companies that choose
middle-of-the-road accounting methods.
The case also highlights the relationship between managers, analysts, and capital
markets. It also illustrates the role financial accounting plays in these interactions.
Cost accounting and managerial accounting:
None.
Patton Corporation
Financial Accounting:
The case illustrates possible ways to record revenue. They include: (1) recognizing
all revenue when a contract is signed; (2) recognizing revenue as it is received, and matching
it with a pro-rata share of costs; or (3) recognizing revenue as it is received and offsetting it
entirely with costs until all costs are recognized.
There are relatively detailed rules on when each revenue recognition method should be
used, but the rules depend heavily on management’s belief about how reliably it can estimate
the ultimate selling price, and how reliably it can estimate the amount that will be collected.
There are also different rules for different industries. In practice, however, the rules give
management a great deal of flexibility.
Financial Accounting from a management perspective:
This case illustrates how managers can rationally argue they are simply reflecting the
economics of their business even though the accounting they use is highly aggressive. For
example, Patton records the entire selling price as revenue when it receives at least 10% of the
sales price in cash (the minimum amount allowed by accounting rules). Patton also argued
that it had virtually no defaults, so there was no reason to have more than a minimal
allowance for doubtful accounts.
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Although that sounds rational, the executives in this class who have banking
experience would never even consider making loans on this type real estate with 10% down.
In fact, some would be reluctant to make such loans with 70% down.
In addition to illustrating how much flexibility management has with regard to
accounting policies, this case also introduces the idea that markets may not be entirely
efficient. It is likely that sophisticated investors avoided Patten, but the firm was able to raise
significant equity funding from individual investors using a smaller brokerage firm.
Cost accounting and managerial accounting:
We considered how much revenue Patton would need to collect to break even. Since
Patton spent about 30% of the selling price on sales and administration, and the land cost was
about 50% of the selling price, Patton must collect 80% of the selling price to break even.
Circuit City Stores (A) and (B)
Financial Accounting:
This case illustrates the accounting rules for repair and maintenance contracts. In
particular, the FASB requires that companies spread the up-front revenue over the live of the
contract. In the case of Circuit City, accounting rule makers changed their policy. Since
Circuit City’s repair costs were minor relative to revenue, the FASB had allowed Circuit City
to recognize almost all revenues at the time of sale. It then changed the rules and required
Circuit City to spread revenues over the life of the contract relative to expected repair costs.
This illustrates that accounting is far from an exact science. It also illustrates that
rules change and that sometimes those rules do not seem to match economic reality.
Financial Accounting from a management perspective:
Circuit City and other electronics retailers changed how they conduct business as a
result of this accounting rule. That is, the outsourced their warranty business. As a result,
once they sold a warranty, a third party assumed all warranty liabilities. As a result, Circuit
City could immediately recognize all of its commission revenue from selling a warranty. That
change probably reduced Circuit City’s profitability as it outsourced a business that the local
stores might have operated best.
Cost accounting and managerial accounting:
None.
LIFO or FIFO? That is the Questions
Financial Accounting:
We briefly looked at the accounting rules for LIFO and FIFO.
Financial Accounting from a management perspective:
Three companies switched inventory accounting methods, two from FIFO to LIFO
and one from LIFO to FIFO. This illustrated that management can select its accounting
methods and can change them. It also illustrated that management typically selects
accounting methods that will further its business objectives. In some cases the overriding
objective is to reduce taxes (the two firms that switched from FIFO to LIFO). In other cases
the overriding objective is to show a higher net income (the firm that switched from LIFO to
FIFO).
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Cost accounting and managerial accounting:
We discussed the technical details of dollar value LIFO and demonstrated that LIFO
can be relatively simple to implement. However, we also discussed the need to review LIFO
with a firm’s external auditors and possibly the need to obtain prior approval from the IRS.
We also discussed standard cost accounting systems and how they allow firms to
switch from FIFO to LIFO or LIFO to FIFO with almost no effort (other than the work
associated with CPA firm and IRS approval, which can be a considerable effort).
Depreciation at Delta Air Lines and Singapore Airlines (A)
Financial Accounting:
We briefly discussed the basics of depreciation accounting, including choice of
accelerated methods or straight-line depreciation, choice of asset life, and choice of salvage
value.
Financial Accounting from a management perspective:
This case illustrated how companies differ in their choice of accounting estimates for
asset life, and how they change asset lives to increase or decrease net income.
We also considered how to adjust financial statements to better compare results for
different companies. For example, even though Delta Air Lines and Singapore Airlines both
changed to less conservative accounting policies over the years, Delta Air Lines consistently
used more liberal accounting methods than Singapore Airlines.
One way to compare the firms would be to lengthen the lives of Singapore’s planes;
the other way would be to shorten the lives of Delta’s planes. However, before we did that,
we should consider whether there are economic differences between the two firms that justify
their different asset lives. For example, if Delta used its planes less heavily than Singapore, it
might justifiably use longer asset lives.
One item that we need not consider as much is how often the airlines replace their
planes. For example, Singapore does have newer airplanes than Delta, but that does not
necessarily imply that it should use shorter asset lives. For example, if Singapore sells its
planes after ten years and delta sells its planes after twenty years, that does not imply they
should use asset lives of ten and twenty years respectively. At the end of ten years
Singapore’s planes may be just as valuable as Delta’s. The depreciation method should,
ideally, reflect the asset’s value over time. In practice, depreciation is simply a way to
allocate costs over future periods.
Cost accounting and managerial accounting:
None.
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Kansas City Zephyrs Baseball Club
Financial Accounting:
Minor.
Financial Accounting from a management perspective:
This case illustrated accounting for items such as signing bonuses, deferred
compensation, guaranteed salaries, roster depreciation. There are few accounting rules for
most of these issues, so accountants need to use their best judgment. However, management,
not by external accountants, issues financial statements. For that reason, management is able
to show overly conservative or overly liberal accounting numbers.
In the case of athletic teams, usually wealthy individuals or groups of individuals own
the teams. They have no reason to provide optimistic accounting numbers and many reasons
to provide pessimistic numbers. Teams with losses can claim they are unable to pay high
salaries and can argue they need financial assistance from the local community. The issues
are technical and in many cases the liability is an estimate that relies on discounting future
payments, which requires an estimated discount rate. That discount rate can be selected by
management, which may select a low rate so as to show a higher liability.
Cost accounting and managerial accounting:
The case also illustrated related-party transactions between the ball team and
organizations such as the stadium, concessions, radio and television stations, and parking lots.
As with any related-party transaction, management has considerably leeway in choosing
transfer prices between the two organizations. That gives management the ability to show one
organization as being highly profitable and the other as being highly unprofitable. The basic
issue is that if a firm enters into a joint arrangement with another firm, it must be very careful
to establish up front how transfer prices will be set (as well as how costs will be determined—
see the following case, Janet O’Brien, CPA).
Janet O’Brien, CPA (briefly)
Financial Accounting:
None.
Financial Accounting from a management perspective:
We did not have time to discuss the issue, but of the four nursing homes, only the nonfor-profit home had much equity financing. The others were financed primarily be debt. The
State’s rules paid homes a 7% return on equity, which is very low. As a result, the for-profit
homes borrowed money, primarily from related parties, at an interest rates well above 7%.
Cost accounting and managerial accounting:
This case considered the idea that “cost” is a fluid term. In particular, when two
organizations enter an agreement that is based on cost, they should very carefully define
“cost.” For example, nursing homes were reimbursed for transportation costs. Those ranged
from expensive cars and motor homes to boats, airplanes and even a railroad car. If one
organization is allowed to define cost after the agreement is in place, it can very easily take
advantage of the other organization. In addition, even when there is no “bad faith,” there will
likely be disagreements if “cost” is not defined in the initial agreement.
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Baylor Books
Financial Accounting:
This case illustrates the rule that firms must establish an allowance for returns.
Financial Accounting from a management perspective:
The primary issue is whether this is a profitable operation or not. The owner is
initially pleased with the reported profit. However, the new controller pointed out that Baylor
Books should establish a reserve for book returns, which will lower reported net income. The
issue is how much net income will be lowered.
Cost accounting and managerial accounting:
This case first establishes the need to understand an industry in detail. At first glance,
returns seem relatively minor and stable over time. When we determine that books are
returned with about a six-month lag, however, we learn that returns are far higher in the
second half of the year than in the first half of the year. We also learn that returns are
increasing over time to the industry average of about 40%.
If returns were smaller in the second half of the year, Baylor Books would have been
reasonably profitable in 1997. Because returns are larger in the second half of the year and
growing, Baylor Books is probably still a breakeven operation.
The case also provided another chance to consider opportunity costs. The owner
wonders whether to cancel ten books to save money, since HarperCollins cancelled over 100
books in an effort to save money. When we consider the variable costs of publishing the ten
books, they are clearly less than the revenue from the ten books. Thus, Baylor will probably
be worse off financially and will also incur ill will from both authors and agents.
In the case of HarperCollins, however, the number of books being cancelled is so large
that it may offer HarperCollins a chance to restructure and eliminate fixed costs. Those cost
savings may be enough to justify the ill will from authors and agents.
We also considered the type of cost system that Baylor Books needs. Because Baylor
does not produce its own books, its cost accounting needs are quite minimal. It would be very
easy to establish a cost system. The only issue is how to allocate fixed costs.
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Interco (briefly)
Financial Accounting:
None.
Financial Accounting from a management perspective:
We considered a firm that borrowed heavily and then paid a massive dividend. In fact,
Interco was bankrupt the day it paid out its dividend. We discussed how management has the
ability to make financial projections that are so favorable that it can pay a massive dividend
and still not violate the law. That is, business is quite complex. In the absence of clear
evidence that indicates otherwise, courts assume that management knows more about the firm
than anyone else, that management acts in the best interests of shareholders, and that
management’s actions should not be judged with hindsight.
Cost accounting and managerial accounting:
None.
Harnischfeger
Financial Accounting:
This case expands on consistency. Harnischfeger changed accounting methods,
accounting estimates, changed year ends, closed its pension plan, changed the estimated
return on pension plan assets, had Kobe Steel pay for part of its R&D and changed how it
reported sales of Kobe Steel products (from gross profit to revenues less cost paid to Kobe).
The course serves as a review of LIFO inventory accounting and straight-line versus
accelerated depreciation. It also introduced pension accounting, which we will cover in more
detail later in the course.
Financial Accounting from a management perspective:
This case focuses on how management can choose accounting methods that are either
more or less conservative to support the firm’s objectives. In particular, management may be
concerned about incentive bonuses, loan covenants, boost the stock price, facilitate the sale of
bonds or stock, or improve the company’s image with employees, prospective employees,
customers, and suppliers.
The case also considers the idea of efficient markets. In particular, is the market
fooled by changes in accounting policies? Harnischfeger’s CFO stated that he believes
investors clearly see through one-time changes. He also believes that investors have far more
trouble evaluate the effect of various accounting changes over time. That is, some changes
effect only the current period, some changes effect future periods, and some changes effect
prior periods through restated financial statements. He believes investors are not able to
properly evaluate all of those changes. We will consider this issue with the first few cases
after the mid-term exam.
Cost accounting and managerial accounting:
None.
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