Emerging Topics in

13 Managerial Accounting
After studying Chapter 13, you
should be able to:

1 ▶ Explain enterprise risk

management and its
importance for achieving
strategy.
2 ▶ Understand the role of
managerial accounting in
business sustainability.
3 ▶ Define quality costs and
describe the approaches
used for reporting and
controlling quality costs.
4 ▶ Describe the basics of lean
manufacturing and lean
accounting.
5 ▶ Explain the role of the
management accountant
in the international
environment.
6 ▶ Explain the role of the
management accountant
in fraud and forensic
accounting.
CARL COURT/Stringer/Getty Images

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 EXPERIENCE MANAGERIAL DECISIONS
with UPS

This chapter provides an overview of several important emerging business issues

and their exciting impact on managerial accounting. UPS exemplifies how
managerial accounting plays an increasingly vital role in these emerging areas
to help improve decision-making and create shareholder value. For example,
UPS’ business model is based on its ability to drive trucks and fly planes across
the globe delivering packages. High quality delivery service is critical for UPS.
By delivering packages on time and without damage, UPS can satisfy both
the retailers and distributors who are shipping their goods and the customers
who are buying those goods. However, for UPS, finding cost-efficient ways
to provide high service quality is also vital for its
financial success. Thus, searching for ways to
eliminate waste and become a lean service provider
“The continued success
is an integral part of the UPS business model. In
fact, it is fully compatible with the company’s of UPS’ business model
original slogan: “Best service and lowest rates.” necessitates that managerial
In providing its delivery services, UPS accountants provide
employs nearly 450,000 workers, handles almost
executives with information
70 million daily tracking requests, and uses
approximately 105,000 vehicles (cars, vans, to help them understand
trucks, and motorcycles) and 650 planes to and manage key risks,
deliver over 4.7 billion packages and documents
such as carbon emissions.
annually. The continued success of UPS’
business model necessitates that managerial Companies refer to this
accountants provide executives with information emerging business area as
to help them understand and manage key risks, enterprise risk management.”
such as carbon emissions. Companies refer
to this emerging business area as enterprise
risk management. UPS also faces numerous
opportunities to innovate the company’s delivery fleet options, such as
decreasing carbon emissions and saving money through materials and end-
of-life fleet recycling, alternative fuel technologies, and GPS and telematics
technologies for maximizing route efficiencies. Identifying these types of
opportunities to create economic, social or environmental value for the
organization represents the rapidly emerging area of business sustainability.
As a global company, UPS faces international issues in business every day. The
various currencies in which it deals require sophisticated knowledge of currency
risk and ways to mitigate it. The use of the internet by customers requires UPS
to employ fraud prevention and detection. Customer account numbers and
payment methods must be secured and financial information protected.
As illustrated throughout this chapter, managerial accountants are well
suited to support business decision making in these varied emerging areas.

701

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702 Chapter 13 Emerging Topics in Managerial Accounting

This chapter provides an overview of several important emerging business issues and their
impact on management accounting. Each issue uses relatable examples to illustrate management
accounting’s increasingly important role within organizations and how it improves decision
making across these issues.

O BJE C T I V E 1 ▶
ENTERPRISE RISK MANAGEMENT
Explain enterprise risk management
and its importance for achieving Managers often make business decisions that require them to consider future events, such as the
strategy.
success or failure of new products or services under development, regulatory actions, economic
conditions, the actions of competitors, and employee talent pools. Such future events usually in-
volve considerable uncertainty as to how they will actually play out in reality. As a result, compa-
nies face considerable risks that must be effectively managed. For example, of the 500 companies
that appeared on the first Fortune 500 list of the world’s biggest companies (as measured by sales
revenue) in 1955, only 11% remain in business, including General Motors, Coca-Cola, IBM,
and General Electric. In other words, eighty-nine percent of the original Fortune 500 compa-
nies have failed to manage their risks in a successful enough manner to remain in business!
Not surprisingly, most investors do not like uncertainty. As a result, companies that are able
to make more effective decisions in the face of uncertainty often are rewarded by key stakehold-
ers in various ways, such as with a lower cost of borrowing (i.e., interest rates), more success in
hiring and retaining top talent (i.e., employees), attracting additional investor capital (e.g., from
investors who share the company’s shareholder return time horizon), or relatively less regulatory
scrutiny (e.g., fewer regulatory requirements, lower fines for any violations, etc.).
Here’s Why It’s important Enterprise risk management helps an organization make better decisions in uncertain business
environments and, most importantly, to achieve its chosen strategy (e.g., to create the most innovative
products or services; to provide the lowest cost products or services; to offer the highest quality prod-
ucts or services). Specifically, enterprise risk management (ERM) is the formal process of aligning
an organization’s overall desired level of risk taking with its strategy, and then managing its top risks
in a manner that maintains this alignment. Over 90% of large organizations (i.e., sales revenues > $1
billion) engage in some type of ERM, ranging from having a complete, formal ERM process in place
to investigating the concept of ERM. However, despite such widespread adoption, the complexity and
relative newness of ERM mean that most organizations have yet to perfect their ERM systems.1 As
such, as reported in CFO surveys and illustrated throughout this section, ERM represents a growing
area of importance and opportunity for management accountants to create value within organizations.2
Exhibit 13.1 presents an overview of the key steps within the ERM process examined in
this chapter.

Exhibit 13.1
Key Steps within the ERM Process • Risk Appetite Determination: Determine the organization’s desired overall level
of risk taking that should be pursued to generate the financial returns expected by
shareholders and other key stakeholders.
• Risk Identification: Identify top risks.
• Risk Assessment: Assess top risks at the inherent level.
• Risk Response: Using a portfolio perspective, identify, evaluate, and implement the
best response alternatives for inherent risks that bring the portfolio of residual risks into
alignment with the organization’s risk appetite.
• Risk Monitoring: Continually search for new emerging risks, reevaluate accuracy of risk
assessments, and consider more effective risk response alternatives.

1 Mark Beasley, Bruce Branson, and Bonnie Hancock, The State of Risk Oversight: An Overview of Enterprise Risk
Management Practices, 7th Edition (American Institute of Certified Public Accountants, April 2016). Taken from
[Link]
AICPA_ERM_Research_Study_2016.pdf
2 David McCann, “Finance and Accounting Skills Gap Vexes CFOs: The Wish List of Traits Desired in Entry-Level
Finance and Management Accounting Staff Continues to Expand,” [Link] (February 4, 2015). Taken from http://
[Link]/training/2015/02/you-just-cant-get-good-help-anymore-accounting-skills-gap/.
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 Chapter 13 Emerging Topics in Managerial Accounting 703

Determining Risk Appetite

An organization’s overall desired level of risk taking is referred to as its risk appetite. Risky
Business Company manufactures Adirondack chairs with a strategy of providing the highest
quality chairs for use in luxury beach and vacation homes. Panel A of Exhibit 13.2 shows Risky
Business Company’s risk appetite as the line that connects the horizontal axis (i.e., likelihood)
and the vertical axis (i.e., impact). The company’s risk appetite can be considered moderate
in nature because it is neither very near nor very far from the origin but rather connects the
midpoints of the likelihood and impact axes.

Exhibit 13.2 Key Elements of a Portfolio Risk Management Perspective

Impact Impact Impact

IR1 IR1

IR4
IR2 IR IR2
4
RR1
IR3
Risk Appetite IR5 Risk Appetite IR3 RR4 Risk Appetite
Likelihood Likelihood Likelihood

Panel A: Risk Appetite Panel B: Inherent Risks Panel C: Residual Risks

Identifying Top Risks

After determining its risk appetite, a company next identifies its most important risks. Some
managers or board of director members refer to these most important risks as a Top 10 list or,
more casually, as the risks that “keep them up at night.” Risk identification requires input from
a cross-functional team to capture all of the perspectives of the organization to understand the
threats—or risks—to the organization. Most companies separate identified risks into various
categories, such as strategic risk, operational risk, compliance risk, financial reporting risk, etc.,
that can be further tailored to the specifics of a particular company or industry. Each top risk is
assigned a “risk owner” who has responsibility for overseeing the successful management of that
risk throughout the ERM process.

Assessing Inherent Risks

After being identified, management must assess top risks at the inherent level. An inherent
risk is the risk that exists absent of any risk management action to reduce or avoid the risk.
Most ERM programs assess, or estimate, two aspects of uncertainty for inherent risks—
(1) the likelihood, or probability P, of an event occurring and (2) the impact, or magnitude,
on the company should an event actually occur. Probability P is measured as falling between
0 (no chance of occurring) and 1 (will occur for sure)—(i.e., 0 ≤ P ≤ 1). Impact can be mea-
sured in qualitative terms (e.g., company reputation), in nonfinancial quantitative terms (e.g.,
percentage of quality defects), or financial quantitative terms (e.g., additional costs incurred or
revenues lost). Both probability and impact are difficult to quantify. Managers increasingly rely
on the measurement expertise of management accountants to estimate these amounts. Panel B
of Exhibit 13.2 plots Risky Business Company’s five most important inherent risks (IR) shown
as IR1 through IR5.

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704 Chapter 13 Emerging Topics in Managerial Accounting

Here’s How It’s Used: AT A D I D A S G R O U P

ERM analyses contain extremely confidential internal information and, as a result, companies rarely share them publicly.
However, the chart below displays an excerpt from adidas Group’s annual report that illustrates how this large (over
$18 billion in annual sales) international sports apparel and equipment company considers the impact and likelihood of its
most critical risks.3

02 CORPORATE RISK EVALUATION CATEGORIES

Highly probable >85%

Probable 50–85% Material risks

Likelihood

Likely 30–50%

Possible 15–30%

Unlikely <15%

Marginal Minor Moderate Significant Major

Financial ≤€ 1 million € 1 million – € 10 million – € 50 million – ≥€ 100 million

equivalent1 € 10 million € 50 million € 100 million

Qualitative Almost no media Limited local media Local and Limited National and Limited Extensive international
equivalent coverage coverage media national international media media coverage
media coverage coverage

Almost no senior Less than 5% additional 5% – 10% additional 10% – 20% additional Over 20% additional
management senior management senior management senior management senior management
attention attention attention attention attention
Potential impact

Risk classification: Marginal Minor Moderate Significant Major

1 Based on operating profit, financial, result or tax expenses.

The axis labels are flipped from that of Exhibit 13.2. Nevertheless, the risk chart is interpreted in the same basic manner—
the further from the origin, the greater the risk as measured by likelihood of occurrence and the potential impact should it
occur. In addition to its adidas Originals, Sports Performance, and Sports Styles brands, the Group also owns the Reebok and
TaylorMade brands. The adidas Group has a risk and opportunity management system for carrying out an ERM process similar
to the one examined in this chapter. For example, its annual report states that the “risk and opportunity management system
ensures risk-aware, opportunity-oriented and informed actions in a dynamic business environment in order to guarantee the
competitiveness and sustainable success of the adidas Group.” Examples of top risks identified and managed by its Risk and
Opportunity Management System include strategic risks (e.g., product distribution risks, competition risks, and sociopolitical
and regulatory risks), operational risks (e.g., personnel risks, business partner risks, IT risks, and inventory risks), legal and
compliance risks (e.g., customs and tax regulations), and financial risks (e.g., currency risks, impairment of intangible assets,
liquidity risks, and credit risks). With an effective and transparent ERM process, adidas Group more effectively pursues its
mission to “strive to be the best sports company in the world, with brands built on a passion for sports and a sporting
lifestyle!”

3 From adidas Group’s 2015 Annual Report, p. 158. Taken from [Link]
e9/73/e973acf3-f889-43e5-b3c0-bc870d53b964/2015_gb_en.pdf.

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 Chapter 13 Emerging Topics in Managerial Accounting 705

Responding to Risks Using a Portfolio Perspective

Once management assesses its top risks at an inherent level, the next step in the ERM process
is to decide how best to manage, or respond, to each top risk. A residual risk is the risk that
remains after any risk management action has been taken. ERM uses a portfolio perspective to
help decide how to respond to each top inherent risk in the most effective manner. A portfolio
ERM perspective is the practice of managing the company’s most important risks in a collec-
tive (or portfolio) fashion, such that the residual risks that remain align with the company’s risk
appetite.
Generally, there are three alternatives for responding to an inherent risk: (1) accept,
(2) avoid, or (3) reduce. To accept an inherent risk means that the company does nothing in
response—it simply continues conducting business as normal. Many risks are managed this way
simply because companies do not have enough money and personnel resources to reduce all of
their top risks. With this response, the residual risk is the same as the inherent risk because no CONCEPT CLIP
response action is taken.
To avoid an inherent risk means that the company ceases to perform the activity that
gave rise to the risk. Some top risks are avoided because the company cannot reduce the
risk in a cost-beneficial manner and it is unwilling to allow the risk to remain at its cur-
rent inherent level. With this response, there is no residual risk because the risk itself is
removed from the company as a result of the company no longer performing the activity that
caused the inherent risk to exist. For example, companies might sell off a business unit or
product or service line if management believes it cannot manage the associated risk(s) in a
cost-beneficial manner.
Finally, to reduce an inherent risk means that the company enacts some particular pro-
cedure to decrease the inherent risk to a lower residual risk level. Possible risk reduction
procedures include a specific activity or internal control (e.g., separation of duties), insur-
ance policy (e.g., a fire or other catastrophic event insurance policy on a warehouse facil-
ity), strategic alliance (e.g., a product toy tie-in between Disney’s Pixar and McDonald’s
restaurants), or even an entire business process (i.e., a collection of related business activ-
ities, such as brand management or barista training for Starbucks). With this response,
the residual risk will be lower than the inherent risk as a result of the chosen risk reduction
alternative.

Net Benefit of Risk Response Each risk response alternative produces a benefit. Risk
response benefit can be defined as the difference between the inherent risk and the residual
risk produced by the particular risk response. Inherent risk is the probability (or likelihood) of a

Here’s How It’s Used: AT G O O G L E

China has more than twice as many people using the Internet human rights activists. Given that Google had invested 4 years
as the United States has citizens, and yet Google elected to in developing its Chinese market offering, management
exit its Chinese search engine business in 2010, thereby losing undoubtedly considered a risk reduction response action
a tremendously large market.4 Google chose this avoidance instead. However, the incremental direct and indirect costs of
action to avoid the risk of censorship from the Chinese reducing these negative impacts appeared to outweigh the
government, whose impact was measured by cyber attacks benefits of doing business in this large, emerging market. The
that targeted the company from within the country, as well end risk response result—at least for a number of years—was
as dozens of other companies and even various Chinese risk avoidance by exiting the market.

4 Kaveh Waddell, “Why Google Quit China—and Why It’s Heading Back,” The Atlantic ( January 19, 2016). Taken from
[Link]

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706 Chapter 13 Emerging Topics in Managerial Accounting

risk occurring multiplied by the impact should it actually occur, which in essence is an expected
value calculation. Residual risk is calculated in the same manner, except that the equation uses
the probability and the impact that are expected to exist after the risk response in question has
been implemented (i.e., the residual amounts).

Risk Response Benefit = Inherent Risk – Residual Risk

Most risk responses also incur a cost in order to be implemented. Risk response cost can be
defined as the incremental cost incurred by the company to implement the given risk response.
This incremental cost (see Chapter 8 for a discussion of incremental, or relevant, costs) can in-
clude both direct and indirect costs (see Chapter 4 for a discussion of direct and indirect costs)
and often is quite challenging to estimate accurately.5 Management accountants can add tremen-
dous value to organizations by accurately estimating the incremental costs of each risk response
alternative under consideration.
Effective ERM requires that management evaluate and implement the most appropriate
risk response to each top risk—in other words, the response that generates the greatest positive
net benefit. Risk response net benefit is measured as the benefit of risk response minus the cost
of risk response.

Risk Response Net Benefit = Response Benefit – Response Cost

Only after risk response costs have been accurately estimated and subtracted from the
response benefit can management estimate the net benefit of each risk response alternative
and select the best course of action (i.e., the alternative with the greatest positive net bene-
Here’s Why It’s important fit). Management must understand how to evaluate multiple risk response alternatives and
select the one that best manages the given risk in a cost-effective manner. Example 13.1
illustrates how net benefit can be used to evaluate and select between risk response
alternatives.
Returning to Risky Business Company, Panel C of Exhibit 13.2 (p. 703) plots Risky’s resid-
ual risks (RR) shown in orange as RR1 and RR4. Assume that IR1 represents the inherent risk of
poor-quality wooden materials being purchased and used in the production of its Adirondack
chairs. Panel C shows that Risky Business management chose to reduce IR1 down to the lower
RR1 level to be in alignment with the company’s risk appetite. Similarly, Panel C shows that
management also chose to reduce IR4 down to the lower RR4 level. Furthermore, manage-
ment chose to avoid IR5, as evidenced by the absence of either an IR5 or a RR5 from Panel C.
In other words, IR5 was deemed too significant simply to accept (i.e., do nothing), and yet
also was too costly to reduce to a point where its residual risk aligned with the company’s
overall risk appetite. Finally, when considered in isolation, IR2 is too risky (i.e., it exceeds the
risk appetite) and IR3 is not risky enough (i.e., it falls below the risk appetite line—investors
will demand a higher return than what will be generated by this overly conservative position).
However, IR2 exceeds the risk appetite line by approximately the same amount that IR3 falls
short of the risk appetite line. When considered from a portfolio perspective, IR2 and IR3
Here’s Why It’s important offset each other and, thus, together align with the company’s risk appetite line. ERM uses
a portfolio perspective to ensure that the organization’s most important residual risks are
aligned with its risk appetite, thereby helping the organization achieve its strategy. The final
risk plots shown in Panel C show that Risky Business Company’s portfolio of residual risks
align with its risk appetite.

5 B. Ballou, D. Heitger, and T. Schultz, Measuring the Costs of Responding to Business Risks. Management
Accounting Quarterly, Vol. 10, No. 2 (2009): 1–11.

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 Chapter 13 Emerging Topics in Managerial Accounting 707

EXAMPLE 13.1
Swift Ascent Backpacking Company provides various outdoor adventure services to climb-
ers visiting Mount Rainer National Park. One of its most popular services is a guided 12-
mile hike from Paradise Lodge to the main Base Camp where climbers can make their final How to Use Net
ascent to the summit of the mountain. Swift Ascent’s management is concerned about Benefit to Evaluate
the additional costs the company would incur from potential lawsuits and fines resulting Risk Response
from injured climbers. The chart below contains a description of this top risk, an inherent Alternatives
risk assessment, three risk response alternatives, and a residual risk assessment for each
response alternative.

Inherent Risk Risk Response Residual Risk

Impact Impact
(operating (operating
Risk Likelihood costs) Alternatives Likelihood costs)
Climbers become either sick A—Require an intensive day-
or injured during their 12- long training and education
10% $ 6,000,000
mile hike from Paradise Lodge seminar for all climbers the
to Base Camp, resulting in 20% $10,000,000 day before their climb
costly lawsuits from climbers B—Form an alliance with the
and fines from the National leading outdoor gear company
Park Service (both of which that guarantees climbers use
increase operating costs for 15% $ 5,000,000
the best performing gear
Swift Ascent) (boots, ice picks, oxygen
masks, etc.) on the market
C—Take no action in
response to possible new 20% $10,000,000
lawsuits or fines

Swift Ascent’s management accountants estimate that the incremental cost of implementing
risk response A is $550,000 and the incremental cost of implementing risk response B is
$300,000.
Required:
1. Calculate the inherent risk for Swift Ascent.
2. Calculate the residual risk for Swift Ascent associated with each of the three risk
response alternatives A, B, and C.
3. Calculate the benefit for Swift Ascent associated with each of the three risk response
alternatives A, B, and C.
4. Calculate the net benefit for Swift Ascent associated with each of the three risk
response alternatives A, B, and C.
5. Using net benefit as the criterion, which risk response should Swift Ascent choose to
implement?
Solution:
1. The inherent risk for Swift Ascent equals the likelihood of the risk occurring multiplied
by the impact that is expected should the risk actually occur.
Therefore, the inherent risk (IR) is:
= 0.20 (likelihood) × $10,000,000 (impact) = $2,000,000
(Continued )

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708 Chapter 13 Emerging Topics in Managerial Accounting

EXAMPLE 13.1
2. The residual risk associated with a particular risk response alternative equals the
likelihood that remains after the alternative is implemented multiplied by the impact
(Continued )
that remains after the alternative is implemented.
Therefore, residual risk (RR) for response alternative A is:
= 0.10 (likelihood) × $6,000,000 (impact) = $600,000
Therefore, residual risk (RR) for response alternative B is:
= 0.15 (likelihood) × $5,000,000 (impact) = $750,000
Therefore, residual risk (RR) for response alternative C is:
= 0.20 (likelihood) × $10,000,000 (impact) = $2,000,000
3. The benefit associated with a particular risk response alternative equals the inherent
risk (IR) minus the residual risk (RR).
Therefore, the benefit for risk response alternative A is:
= $2,000,000 (IR) – $600,000 (RR) = $1,400,000
Therefore, the benefit for risk response alternative B is:
= $2,000,000 (IR) – $750,000 (RR) = $1,250,000
Therefore, the benefit for risk response alternative C is:
= $2,000,000 (IR) – $2,000,000 (RR) = $0

4. The net benefit associated with a particular risk response alternative equals the benefit
minus the cost.
Therefore, the net benefit for risk response alternative A is:
= $1,400,000 (benefit) – $550,000 (cost) = $850,000
Therefore, the net benefit for risk response alternative B is:
= $1,250,000 (benefit) – $300,000 (cost) = $950,000
Therefore, the net benefit for risk response alternative C is:
= $0 (benefit) – $0 (cost) = $0
5. Using net benefit as the criterion, Swift Ascent should select and implement risk
response alternative B because this option has the greatest positive net benefit,
$950,000, as compared to alternative A, $850,000, or alternative C, $0.

Monitoring the ERM Process

Finally, risk monitoring means that management proceeds through the ERM process in
an iterative fashion, continually looking for ways to improve any and all steps along the
way. One common mistake made by management in implementing ERM is treating it as
a checklist that simply requires one-time consideration. Instead, management should ini-
tially proceed through the complete ERM process and then return each year to begin the
process again.
Well-run companies continuously look for ways to improve their ERM process and turn
to management accountants to play an important role in providing key inputs into each step
of the ERM process. For example, management accountants can help continually reevaluate
key inputs, such as identifying emerging—yet previously ignored—risks and reassessing the

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 Chapter 13 Emerging Topics in Managerial Accounting 709

stated risk appetite to verify that it aligns with the company’s strategy and expectations from
key stakeholders. Furthermore, from a measurement perspective, management accountants
should play an important role in more creatively and accurately estimating inherent risks, the
incremental cost of specific risk response alternatives, the residual risk that is expected to be
achieved from the selected risk response plan, and the residual risk that actually is achieved
after the selected risk response plan has been implemented. Finally, risk correlation—the ex-
tent to which one risk or risk response is associated with other risks—represents a growing
challenge for management accountants to employ data analytics to substantially improve the
ERM process.

Check Point
1. Which step within the ERM process should occur immediately after risk
assessment?
Answer:
Risk response follows risk assessment and involves the identification, evaluation, and
implementation of the best risk response alternatives for the organization’s top inherent
risks.
2. The decision to form a strategic alliance with a new business partner to respond
to the risk of low product quality represents an example of which risk response
alternative?
a. Accept
b. Avoid
c. Reduce
d. None of these.
Answer:
c. A strategic alliance is an example of a risk reduction alternative as it attempts to
reduce the likelihood, the impact, or both of the given inherent risk.

BUSINESS SUSTAINABILITY OB J ECT I VE ◀ 2

Understand the role of managerial
The term “sustainability” is one of the most often used, yet misunderstood, terms in accounting in business sustainability.
business. For example, some managers equate sustainability with environmental issues,
such as greenhouse gas emissions or other “green” initiatives. While such environmental
issues are important, many additional issues are equally—if not more—important to an
organization’s overall performance. For this chapter, as well as for most successful orga-
nizations, sustainability actually refers to business sustainability. Business sustainability Here’s Why It’s important
is the practice of creating long-term organizational value through internally understand-
ing, measuring, and managing the key threats and opportunities to achieving the organi-
zation’s strategy and then externally reporting to key stakeholders on the successes and
failures of such efforts.
This section focuses on the important and growing role of management accounting in help-
ing organizations practice business sustainability. The business sustainability cycle, shown in

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710 Chapter 13 Emerging Topics in Managerial Accounting

Exhibit 13.3, highlights the interconnectivity of the key management accounting areas within
business sustainability.6

Exhibit 13.3
The Role of Management
Accounting in the Business Strategy
Sustainability Cycle

Sustainability Stakeholder
Assurance Engagement
Business
Sustainability

CONCEPT CLIP
Sustainability Risk
Reporting Management

Performance
Measurement

These areas include (1) organizational strategy, (2) stakeholder engagement, (3) risk manage-
ment, (4) financial and nonfinancial performance measurement, (5) sustainability reporting
and, finally, (6) sustainability assurance. The remainder of this section explores these areas and
how they build upon one another to help make a business more sustainable.

Here’s Why It’s important Strategy Business sustainability begins first and foremost with the company’s strategy. Selecting
the company’s strategy is an important decision usually made by the CEO. However, perhaps even
more important than selecting the best strategy is implementing the selected strategy in an effective
manner. Effective strategy implementation requires management to make business sustainability-
oriented decisions that support, rather than conflict with, strategy. For example, as the business sus-
tainability cycle illustrates, effectively carrying out Apple’s strategy of continually designing innova-
tive products in a high profile manner requires management to engage with key stakeholders, measure
and manage risks, and finally report and assure sustainability information in a very different manner
as compared to implementing Costco’s strategy of driving sales, using a no-frills approach without
advertising. Apple’s strategy leads its management to be more concerned with convincing investors
that its various decisions promote an innovative product design culture, whereas Costco’s strategy leads
management to focus more on providing quality products at a price lower than competitors’ prices.

Stakeholder Engagement Stakeholders are those individuals or groups that (1) are affected
by an organization’s pursuit of its strategy or (2) can affect an organization’s ability to achieve its
strategy. In other words, the relationship between key stakeholders and the organization is a two-
way street. Stakeholders can include investors, creditors, customers, employees, regulators, suppli-
ers, competitors, lobbyists, community members, and nongovernment organizations (e.g., Sierra
Club, American Red Cross). Investors (or shareholders) represent the ultimate stakeholder.

6 Exhibit 13.4 is adapted from B, Ballou, D. Heitger, and C. Landes, Accounting for the Sustainability Cycle: How the
Accounting Profession Can Add Value to Sustainability-Oriented Activities (American Institute of Certified Public
Accountants, October 2013). Taken from [Link]
DownloadableDocuments/Sustainability/Whitepaper_Accounting_for_the_Sustainability_Cycle.pdf.
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 Chapter 13 Emerging Topics in Managerial Accounting 711

Here’s How It’s Used: AT D E B E E R S

Business sustainability involves many functions and varies across businesses and industries. One decision that likely will change
your life one day regards marriage and the selection of a diamond engagement ring. You might consider the life cycle of the
ring’s diamond—it almost surely has traveled a great distance and involved a large number of key stakeholders along the way. For
example, founded in 1888, De Beers is one of the world’s best-known diamond companies. De Beers extracts, or recovers, the
majority of its diamonds from Botswana, South Africa, Canada, and Namibia.7 Exhibit 13.4 displays a variety of De Beers’ various
business sustainability issues (both threats and opportunities) along its entire value chain. De Beers’ value chain spans from research
and development Exploration (e.g., the positive and negative political, economic, and social impacts that occur as a result of the
countries where De Beers chooses to explore for diamonds) through customer service Brands/Retail (e.g., changes in De Beers’
reputation for exclusivity and quality resulting from the prices it charges and the retail establishments it uses to sell its diamonds).

Exhibit 13.4 Business Sustainability Issues throughout the Value Chain

A GLOBAL VALUE CHAIN

EXPLORATION PRODUCTION ROUGH DIAMOND SALES CUTTING, POLISHING BRANDS/RETAIL

AND MANUFACTURING

De Beers’ exploration De Beers has both De Beers sells its rough The cutting and polishing De Beers markets
activities are currently underground and diamond production via of diamonds and the polished diamonds to
focused in Canada, open-pit mines in contract sales to customers, manufacture of diamond consumers through
Botswana, South Africa Botswana, Canada and known as Sightholders and jewellery are concentrated Forevermark, which
and Namibia, where we South Africa. Accredited Buyers, and via in Belgium, Botswana, promises a consumer
use highly sophisticated rough diamond auctions. China, India, Israel, that their diamond is
technologies to find and We also commercially Namibia, South Africa beautiful, rare and
determine the economic mine alluvial diamonds As part of our long-term and the United States. responsibly sourced; and
viability of deposits. in Namibia using contract sales, the majority retails diamond jewellery
onshore extraction of De Beers’ diamonds are We aim to support through De Beers
techniques and, in the aggregated and sold at 10 downstream activities Diamond Jewellers, our
sea, specialised ships. Sights (or selling events) such as cutting and independently managed
each year, with the polishing in our countries 50/50 joint venture
Through Element Six, our remainder being sold via of production through our with Moët Hennessy
synthetic industrial online auction. beneficiation strategy Louis Vuitton.
diamond supermaterials (see Economics chapter).
business, we supply tool De Beers has sales
and application operations in Belgium,
manufacturers across a Hong Kong, Israel,
diverse range of global Singapore and the United
markets. Arab Emirates.

As De Beers illustrates, business sustainability requires that management considers the numerous stakeholders, as well as threats
and opportunities, involved with major decisions throughout the company.

However, many organizations increasingly realize that understanding, measuring, and respond-
ing to key stakeholder concerns in an effective and logical manner generally creates smoother and
greater increases in shareholder returns than ignoring stakeholders and their concerns.
Exhibit 13.5 presents results from PricewaterhouseCooper’s survey of 1,409 CEOs from
across 83 countries who were asked to list the stakeholders who had the greatest impact on their

7 Excerpt from De Beers’ “Building Forever: Report to Society” (2015). Taken from [Link]
content/dam/de-beers/corporate/documents/BuildingForever/Report%20to%20Society%[Link].
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712 Chapter 13 Emerging Topics in Managerial Accounting

organization’s strategy.8 Customers, regulators, competitors, employees, supply chain partners,

and investors are the stakeholders with the largest impact on organizational strategy.

Exhibit 13.5 The Relationship Between Stakeholders and Strategy

90% 69% 67% 51% 48% 41%

Customers Government Industry Employees Supply chain Providers of
and clients and regulators competitors (includingtrade partners capital (including
and peers unions) activist investors)
Note: Respondents who indicated high or very high impact

Most managers understand how their organization can affect its stakeholders. For example,
Walmart’s decision to build a new store (or close an existing store) has significant financial,
political, and environmental impacts on the local economy, citizens, employees, utility com-
panies, suppliers, and competitors. These impacts oftentimes are referred to as footprints.
Conversely, managers increasingly realize that the impact can work in the other direction as
stakeholders can influence the organization’s ability to achieve its strategy. For example, current
or potential customers can refuse to buy products as a result of boycotting the opening or closing
of a store, which negatively affects the organization’s ability to meet its strategic and other per-
formance targets. Management accountants can estimate these and other stakeholder impacts
on organizational performance involving a growing or shrinking workforce, more or less quali-
fied employees, the cost of electricity, water, pollution, or other externalities, more or less strin-
gent regulatory requirements, and the amount and cost of equity financing or debt borrowings.
Given the impacts that stakeholders and organizations have on one another, one of the
most important business sustainability challenges for managers is to understand key stake-
holders and the exact issues about which they are most concerned. However, identifying
these key stakeholder concerns is extremely difficult unless the organization has an effective
Here’s Why It’s important stakeholder engagement process in place. Stakeholder engagement is the process by which
an organization’s management interacts with its key stakeholders. Stakeholder engagement
varies from casual, impromptu, informal conversations all the way to regular, structured inter-
actions where both parties exchange data and expectations about one another’s performance.
Managerial accountants can play an important role in quantifying stakeholders’ expectations
about the organization and estimating the extent to which such expectations can impact
(either positively or negatively) the organization’s future earnings, cash flows, or other per-
formance measures.
Exhibit 13.6 is an excerpt from Eli Lilly and Company’s integrated annual report that
showcases its key stakeholders and the channels Eli Lilly employs to engage them.9
Note the variety of measures and approaches used by management to understand key stake-
holders and their concerns.

8 Excerpt from PricewaterhouseCooper’s 19th annual CEO survey entitled “Redefining Business Success in a Changing
World” (2016). Taken from [Link]
[Link].
9 Excerpt from Eli Lilly and Company’s “Integrated Report” (2015). Taken from [Link]
[Link].

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 Chapter 13 Emerging Topics in Managerial Accounting 713

Exhibit 13.6 Stakeholder Engagement Activities at Eli Lilly

Stakeholder Groups and Examples of Engagement Channels Investors Non-Governmental Organizations

Healthcare Professionals Patients › Daily interactions through our investor › Partnerships to support patients and
› Online medical information › Healthcare provider discussions relations function families
resources › Educational materials and programs › Industry investor conferences › Partnerships to raise awareness about
› Disease-state educational programs › Product package inserts and › Meetings in Indianapolis and major certain diseases
› Advisory boards medication guides global cities › Advisory board participation
› Sales force interactions › Patient advocacy groups › Quarterly earnings communications › Participation in annual conferences/
› Direct-mail communications › Patient support and assistance › Annual meeting of shareholders exhibitions
› The Lilly Answers Center telephone programs › Annual report and other financial › Company communications
line › Online product resources disclosures › Memberships
› Medication guides and package › The Lilly Answers Center telephone line › Periodic investment community update Government and Regulatory
inserts Public and Private Healthcare meetings Organizations
› Online registries Administrators › Corporate governance discussions › Policy education materials
› Publications (manuscripts, posters, › Account-manager interactions facilitated by the corporate secretary’s › Published policy research
and abstracts) › Disease-state educational programs office › Responses to written requests for
› Medical letters › Advisory boards Suppliers information
› Patient support programs › The Lilly Answers Center telephone line › Green procurement program › Oral and written testimony
› Lilly-sponsored symposia and › Online medical information resources › Product stewardship standard › Written comments on proposed
scientific exchange meetings Community Members › Supplier self-assessments and regulations
› Medical and commercial booths at › Employee service on boards and qualifications › Policy discussions
congresses committees of local organizations › Supplier audits that Lilly performs › Advisory boards
› Interactions with Lilly physicians, › Participation in local volunteer › Supplier risk-assessment process › Meetings and conferences
scientists, and medical liaisons opportunities › Policy advocacy conversations with › Communication of studies
› Clinical trial investigation contracting › Employee-directed philanthropy vendors › Lobbying activities
› Lilly-sponsored mobile applications Employees1 › Educational briefings
that provide physicians with easy- › Live “global town hall” meetings › Direct legislator and policy-maker
to-access research and clinical trial › Intranet social collaboration/ engagement
information networking tools, including CEO blog
With strong roots in minimizing risk, facilitating governance, and strengthening › Employee resource groups
1 Approximately 41,000 employees as of
relationships, our Office of Alliance Management has been conducting “Voice of › Employee surveys
December 31, 2015.
Alliance” surveys for the past 15 years. Data is regularly collected from Lilly and › Electronic newsletters
alliance partner employees to assess the strategic, cultural, and operational fit of › Hotline for ethics, compliance, and
each partnership and determine how the collaborations can be improved. privacy questions/concerns

Risk Management As discussed earlier, an organization’s selected strategy plays a large part
in determining which stakeholders are most important to the organization. Stakeholders usu-
ally have concerns or expectations about the organization’s performance. Stakeholder concerns
can be thought of as the risks and opportunities that either hurt or help the organization’s ability
Here’s Why It’s important
to achieve its selected strategy (i.e., stakeholder concerns equal organizational risks/opportu-
nities). An effective stakeholder engagement process is extremely helpful in identifying these
stakeholder concerns and recognizing the risks and opportunities they pose to the organization
more quickly than if no such process exists.
More specifically, these risks (or threats) and opportunities vary widely across organiza-
tions and can relate to many different key stakeholder groups and performance areas, including
economic, social, environmental, political, financial, legal, reputational, and regulatory. Some
organizations use acronyms, such as TBL (triple bottom line of economic, environmental, and
social factors) or ESG (environmental, social, and governance factors), to categorize some of the
most common risks and areas of stakeholder concern. Therefore, risk management (discussed
in the previous section) plays a critical role within the business sustainability cycle because it
helps managers focus more clearly on exactly which issues should be measured and managed
internally and, subsequently, communicated to key external stakeholders to increase organiza-
tional value.

Performance Measurement For investors and other key stakeholders, financial mea-
sures, such as future cash flows and earnings streams, usually serve as the ultimate means for
evaluating the effectiveness with which managers make decisions that involve numerous—and
often conflicting—stakeholder concerns. However, organizations have limited resources and
cannot please all key stakeholders all of the time. Thus, managers must make trade-offs when
deciding on which risks and opportunities they choose to address and how to address them.

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714 Chapter 13 Emerging Topics in Managerial Accounting

Here’s How It’s Used: SUSTA I NA BI LI TY

UPS illustrates the important connection between stakeholders, risks, and performance measurement. In essence, UPS’s business model
is predicated on its ability to drive trucks and fly planes all over the globe delivering packages. In so doing, UPS employs over 444,000
workers, handles an average of 69.4 million daily tracking requests, and uses approximately 105,000 vehicles (cars, vans, tractors,
and motorcycles) and 650 planes to deliver over 4.7 billion packages and documents annually.10 As an indication of its environmental
footprint, the company touts that its Orion delivery routing technology will reduce the distance its vehicles drive each year by 100 million
miles. The UPS graph in Exhibit 13.7—with importance to stakeholders shown on the vertical axis and influence on business success
shown on the horizontal axis—shows the relationship between the company’s stakeholder concerns and its business sustainability.

Exhibit 13.7 The Relationship between Stakeholder Concerns and Business Success at UPS

Materiality Matrix
KEY
IMPACT/ISSUE AREA:
Areas of significant UPS sustainability impact.

CONTEXTUAL TREND:
Global trends influencing our business and our sustainability strategy.

Low Medium High

Disaster Relief Labor Relations Customer Privacy
Child Labor, Forced & & Resilience
Supplier Energy, Emissions
Compulsory Labor, Migrant Labor, & Fuel Supply
Engagement
and Human Trafficking Employee Health,
Safety & Wellness Digital & Physical Management of
Asset Security Thiry-Party Representatives
Package Contents Safe Driving Workforce Diversity Transparency High
Trade Barriers
Responsibility & Reporting
Importance to stakeholders

Environmental Ethical Concuct Emerging Markets

Compliance Social
Greenhouse Gas Infrastructure Urban Growth
Toxic Substances Living Wages Policy Recruitment, Training
Management & Development Sustainable Shipping &
Supplier
Fleet Noise Responsible Supply Chain Offerings
Diversity
Marketing
Network Efficiency
Philanthropy &
Volunteering Sustainable Terrorism &
Executive Procurement Political Unrest Public Policy
Compensation

Water Use Health Access Fuel Continuity

Sustainable Medium
& Impact Packaging & Prices
Waste
Management Employee
Engagement
Rail/
Green Facilites
Waterborne Freight
Design
Environmental Impact
Low

Influence on Business Success

Not surprisingly, as evidenced by its inclusion in the upper right-hand corner, UPS’s performance measurement system ranks
Energy, Emissions & Fuel Supply as one of its most important risks, given its extreme importance to stakeholders and influence on
UPS’s performance. From this point, UPS accountants can perform more in-depth analyses to estimate how the most important
stakeholder issues shown in the graph translate into impacts on the organization’s most critical performance measures.

10 From UPS’s “Fact Sheet.” Taken from [Link]

Fact_Sheet_5_18_2016.pdf.

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 Chapter 13 Emerging Topics in Managerial Accounting 715

One of the most common complaints from managers concerning business sustainability is the
lack of financial analysis that compares and contrasts the short- and long-term effects that would
result from various decisions involving key stakeholder concerns. The good news for manage-
rial accountants is that this complaint creates an opportunity for managerial accountants to
add significant value to the organization. Business sustainability is valuable because it improves
decision making by helping managers understand how their various decisions involving risks
Here’s Why It’s important
and opportunities (i.e., stakeholder issues) relate to important performance measures, such as
future cash flow and earnings streams.
As one example of business sustainability trade-offs, consider the various issues and stake-
holder concerns involved with an organization’s overseas manufacturing plants. Would the orga-
nization be better served by spending its limited resources to reduce child labor, increase worker
safety, more carefully inspect raw materials quality, patrol for intellectual property theft (i.e.,
local workers stealing patented technology and producing competing inexpensive “knockoff ”
products), verify that its suppliers follow the agreed-upon Code of Conduct, train workers not
to offer or accept bribes in order to comply with the U.S. Foreign Corrupt Practices law, or
reduce waste and associated product costs? Each of these potential decisions would impact key
stakeholders, but management likely cannot address them all or give them all equal priority.
Increasingly, management accountants play an important role in helping managers better under-
stand the connection between specific decisions and key stakeholder concerns. Understanding
these connections gives managers the ability to measure concerns such as employee safety, envi-
ronmental emissions, regulatory scrutiny, economic constraints, and investor pressures in com-
mon financial terms. As a result, management can make these trade-off decisions in a financially
informed manner rather than randomly responding to the stakeholders who “yell the loudest”
and hoping for the best.

Sustainability Reporting Corporate sustainability reporting (CSR) refers to the vol-

untary public disclosure of qualitative and/or quantitative information about an organization’s
performance on one or more financial and/or nonfinancial dimensions. For example, common
types of information disclosed in CSRs include the TBL and ESG issues discussed earlier. Other
terms for corporate sustainability reporting include corporate responsibility reporting, citizen-
ship reporting, corporate accountability reporting, and nonfinancial reporting. CSR is a rela-
tively recent, yet very impactful reporting phenomenon, both for the organization issuing the
CSR and for the multitude of external stakeholders that make various decisions based on the
information contained within the CSR.
Exhibits 13.8, 13.9, and 13.10 contain excerpts from KPMG’s global survey of corpo-
rate sustainability reporting practices.11 In Exhibit 13.8, the green circles represent data from
the world’s largest (by sales revenue) 250 companies. The purple circles represent data from
the largest (by sales revenue) 100 companies in each of 45 different countries (i.e., 4,500 total
companies represented). Exhibit 13.8 displays how CSR has changed since its inception in the
mid-1990s. Perhaps the most striking observation is the extremely rapid growth—from 0 to
92%—in the percentage of organizations that prepare and issue some form of CSR. This growth
Here’s Why It’s important
has transpired over a relatively short 20-year time period.
All data in Exhibit 13.9 are from the largest (by sales revenue) 100 companies in each of
45 different countries (i.e., 4,500 total companies represented—the purple represents 2015
and the green represents 2013). Furthermore, Exhibits 13.9 (page 716) and 13.10 (page 717)
display the widespread adoption of CSR across nearly every industry and in countries across the
globe, respectively. These observations are important because they further support the notion
that CSR is not a temporary “hot topic” that will quickly fizzle out, but instead has deep roots
and anticipated benefits for the majority of organizations around the world.

11 From KPMG’s “Currents of Change: The KPMG Survey of Corporate Responsibility Reporting” (2015). Taken from
[Link]
[Link].

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716 Chapter 13 Emerging Topics in Managerial Accounting

Exhibit 13.8 Rapid Growth in Corporate Sustainability Reporting Since Its Inception

CR reporting stabilizes at a high level

1993 1996 1999 2002 2005 2008 2011 2013 2015

35% 45%
12% 18% 64%
83% 95% 93% 92%
24% 28%
41%
N100 CR reporting rate 53%
G250 CR reporting rate 64% 71% 73%
Base: N100/G250 companies
Source: KPMG Survey of Corporate Responsibility Reporting 2015

Exhibit 13.9 Widespread Adoption of Corporate Sustainability Reporting across Industries

CR reporting rates by sector

Mining Utilities TMT Automotive Oil Food & Personal Financial Chemicals Forestry Construction Healthcare Transport Industrials, Retail
100% & gas beverage & household services & paper & materials & leisure manufacturing
goods & metals
90
2013
80 2015
70

60

50

40

30

20

10

Base: 4,500 N100 companies

Source: KPMG Survey of Corporate Responsibility Reporting 2015

Corporate sustainability reporting differs from traditional financial reporting (i.e., the 10-K
annual report in general and financial statements in particular) in three major ways. In most coun-
tries and business environments, sustainability reporting is (1) voluntary, (2) not required to fol-
low any particular set of rules when preparing the information contained within the report (i.e.,
unlike traditional financial reporting that must adhere to generally accepted accounting princi-
ples), and (3) not required to have the report contents verified by an independent third party
(i.e., unlike traditional financial reporting that must be assured by an independent third party). It
should be noted that the Global Reporting Initiative and the Sustainability Accounting Standards
Board each have published reporting standards that organizations often choose to adopt when
preparing their CSRs. However, neither of these sets of CSR standards has been widely recognized
as “generally accepted,” nor (as noted above) is the use of any standard required in most places.
These differences might surprise some financial market participants. On the one hand, it
would be hard to imagine publicly traded organizations issuing financial statements that are vol-
untary in nature, or free from following any set of rules, or without any form of verification from
an independent third party (i.e., auditor)—let alone all three, as is the case with CSR! On the
other hand, one must remember that traditional financial reporting regulations have been under

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 Chapter 13 Emerging Topics in Managerial Accounting 717

Exhibit 13.10 The Global Phenomenon of Corporate Sustainability Reporting

development since the early 1930s, when the stock market crash and the Great Depression led
to the first meaningful financial reporting regulations (e.g., Securities Acts of 1933 and 1934).
These rules have continued to evolve over the past 80 years to include current generally accepted
accounting principles. By comparison, CSR has been employed by a majority of large organiza-
tions since only the mid-2000s. Therefore, while far from perfect, CSR is in its infancy relative
to financial reporting and likely will continue to experience significant and frequent changes for
the foreseeable future.

Sustainability Assurance Sustainability assurance is the external verification that an in-

dependent party provides concerning the content of a corporate sustainability report and/or
the process used in preparing a corporate sustainability report. As noted earlier, in most coun-
tries and financial markets, CSRs are not required to be verified (e.g., assured) by independent
third parties. Traditionally, most organizations have found it much easier to estimate the costs of
CSR assurance than the benefits. As a result, only a small percentage of CSRs was assured during
the earliest years of CSR.
However, Exhibit 13.11 shows the slow, yet steady, increase in the percentage of organiza-
tions that have their CSRs assured in some capacity. For example, from 2005 to 2015, those or-
ganizations that had their CSR information assured changed from being in the minority (only
30%) to the majority (63%). In this exhibit, the purple line represents the world’s largest (by
sales revenue) 250 companies, and the green line represents the largest 100 companies in 45
different countries across the globe (i.e., 4,500 total companies represented).

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718 Chapter 13 Emerging Topics in Managerial Accounting

Exhibit 13.11 Growth in independent assurance of CR information

Growth in Independent Assurance 100%
of Corporate Sustainability N100
90 G250
Information
80
70 63%
59%
60
50 46%
40%
40 30%
42%
30 39% 38% 38%
33%
20
10
0
2005 2008 2011 2013 2015

Here’s Why It’s important The most significant benefit of having a CSR assured by an independent third party is
that assurance can increase the believability of the CSR’s content for external stakeholders. In
other words, people are more likely to trust qualitative and quantitative CSR information if it
has been verified by an unbiased party that is unrelated to the reporting organization (i.e., the
CSR issuer). Most managers and external stakeholders agree that CSR assurance is beneficial,
although they acknowledge that measuring the exact size of such a benefit is very challenging.
However, managerial accountants can provide valuable insights by estimating the benefits (and
costs) of CSR assurance with increasing accuracy.
The cost of CSR assurance can be considerable. For example, some managers complain that
assuring only a small part of the CSR can cost more than preparing the entire CSR. Several fac-
tors contribute to these costs. One factor is that the lack of a generally accepted set of reporting
standards for preparing CSRs leads to higher assurance costs because of the various ways that or-
ganizations prepare them. Another factor is the forward-looking nature of CSRs, which means
that they contain information with far greater uncertainty—and thus less accuracy—than tradi-
tional financial reports, which also increases assurance costs. Specifically, assurance firms worry
that stakeholders might pursue legal action against them if stakeholders make decisions or enter
into contracts based on assured CSR information that subsequently is discovered to be materi-
ally inaccurate.

The Challenge of Communicating an Organization’s Business Sustainability

“Story” Many organizations fail to adequately understand the link between changes in mea-
sures of stakeholder concerns (i.e., risks and opportunities) and their eventual financial impact
as measured by costs, revenues, net income, cash flows, or stock price. In other words, organiza-
tions struggle internally to understand their business sustainability “story” as captured via their
most important performance measures. Yet at the same time, many organizations face extreme
pressure to release large quantities of information to satisfy external stakeholders (e.g., regarding
geographic sourcing of materials or ingredients, workforce diversity, executive and employee
compensation, overseas factory working conditions, carbon footprint, etc.).
In a rush to respond to this growing stakeholder demand for greater disclosure, many or-
ganizations prematurely release large quantities of sustainability-oriented information. This re-
actionary approach often results in a “cart before the horse” problem in that CSRs suffer from
information overload (e.g., many CSRs exceed 100 pages) without explaining to key stake-
holders how the company measures and manages its most important risks to achieve strategy.
Additionally, some CSRs do not follow optional reporting rules, thereby resulting in reports
that fail to consider information characteristics such as relevance, reliability, materiality, and

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 Chapter 13 Emerging Topics in Managerial Accounting 719

consistency that are highly important to stakeholders interested in evaluating the organization’s
performance. Finally, many CSRs are not audited, thereby resulting in stakeholder skepticism
regarding the quality or believability of their contents. For example, greenwashing occurs when
stakeholders believe that an organization’s corporate sustainability report contains environmen-
tal (or other types of ) information that is materially biased in favor of the reporting organiza-
tion. Such greenwashing rarely results in positive organizational benefits over the long run.
Therefore, starting with the organization’s strategy and then proceeding through the
business sustainability cycle—as described throughout this section—helps managers un-
derstand the organization’s business sustainability story and effectively communicate it with
key external stakeholders. Interestingly, in a transformational change in reporting practices,
some organizations are moving to the use of integrating reporting to communicate their story.
Integrated reporting occurs when an organization combines its annual report (i.e., 10-K)
with its sustainability report to form one combined (or integrated) report for all stakehold-
ers, including investors. The organization can reap significant benefits as a result of communi-
cating its business sustainability story. The benefits to organizations include more effectively
Here’s Why It’s important
capturing investor capital, securing a lower cost of borrowing, attracting and retaining better
employees, working with higher-quality suppliers, receiving more favorable treatment from
regulators and lawmakers, and eliciting more welcoming treatment from the local communi-
ties in which they operate.

Check Point
1. Which area within the business sustainability cycle immediately follows risk
management?
a. Strategy
b. Performance measurement
c. Sustainability assurance
d. Carbon emissions testing
Answer:
b.
2. For the world’s largest companies, how does the percentage of organizations
that issue corporate sustainability reports compare to the percentage of
organizations that have their corporate sustainability reports externally assured?
Answer:
According to KPMG’s survey of corporate responsibility reporting referenced in
Exhibits 13.8 through 13.11, as of 2015, ninety-two percent of the world’s largest
organizations (i.e., G250) issue a sustainability report, while only 63% of these
companies have their corporate sustainability report externally assured.

QUALITY COST MANAGEMENT OB J ECT I VE ◀ 3

Define quality costs and describe the
A quality product or service is one that meets or exceeds customer expectations. Customers approaches used for reporting and
controlling quality costs.
expect a product to be reliable, durable, fit for use and essentially perform well. In effect, they
expect a product to conform to specifications. In fact, many quality experts believe that quality
of conformance is the best operational definition of quality. Implicitly, a conforming prod-
uct is reliable, durable, fit for use and performs well. The product should be produced as the
design specifies it, and specifications should be met. Conformance is the basis for defining what
is meant by a nonconforming, or defective, product. A defective product is one that does not
conform to specifications. Zero defects means that all products conform to specifications.

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720 Chapter 13 Emerging Topics in Managerial Accounting

Costs of Quality
Whenever a product fails to conform to specifications (i.e., “poor quality” exists), costs are
incurred. Moreover, actions taken to prevent nonconformance also cause costs. Thus, costs
of quality are costs that exist because poor quality may or does exist. Quality costs can be
substantial in size and a source of significant savings if managed effectively. Improving quality
can increase market share and sales, while simultaneously decreasing costs. The overall effect
enhances a firm’s financial and competitive position. There are numerous quality-related ac-
tivities, all of which consume resources that determine the level of quality incurred by a firm.
Inspecting or testing parts, for example, is a quality appraisal activity that has the objective of
detecting bad products. Detecting bad products and correcting them before they are sent to
customers is usually less expensive than letting them be acquired by customers. The objective
of quality cost management is to find ways to reduce total quality costs to 2 to 4% of sales,
the optimal range recommended by quality experts. To achieve this objective, a more detailed
understanding of quality costs is needed. Quality costs can be categorized as control costs and
appraisal costs.

Control costs Control costs are the costs of preventing or detecting poor quality. These
costs are incurred because poor quality may exist. Control costs can be further subdivided into
prevention and appraisal costs.
Prevention costs are incurred to prevent poor quality in the products or services being pro-
duced. As prevention costs increase, we would expect the costs of failure to decrease. Examples
of prevention costs are quality engineering, quality training programs, quality planning, quality
reporting, supplier evaluation and selection, quality audits, quality circles, field trials, and design
reviews.
Appraisal costs are incurred to determine whether products and services are conforming
to their requirements. The main objective of the appraisal function is to prevent noncon-
forming goods from being shipped to customers. Examples include inspecting and testing raw
materials, packaging inspection, supervising appraisal activities, product acceptance, process
acceptance, measurement (inspection and test) equipment, and outside endorsements. Two
of these terms require further explanation. Product acceptance involves sampling from batches
of finished goods to determine whether they meet an acceptable quality level. If so, the goods
are accepted. Process acceptance involves sampling goods while in process to see if the process is
in control and producing nondefective goods. If not, the process is shut down until corrective
action can be taken.

Failure costs Failure costs are the costs incurred because products or services do not con-
form to specifications. These costs tend to be most significant and, like control costs, have two
major subdivisions.
Internal failure costs are incurred when products and services do not conform to specifi-
cations, and this nonconformance is detected before the bad products or services are shipped or
delivered to outside parties. These are the failures detected by appraisal activities. Examples of
internal failure costs are scrap, rework, downtime (due to defects), reinspection, retesting, and
design changes. These costs disappear if no defects exist.
External failure costs are incurred when products and services fail to conform to require-
ments or satisfy customer needs after being delivered to customers. Of all the costs of quality,
this category can be the most devastating. For example, costs of recalls can run into the hundreds
of millions of dollars. Other examples include lost sales because of poor product performance,
returns and allowances because of poor quality, warranties, repairs, product liability, customer
dissatisfaction, lost market share, and complaint adjustment. External failure costs, like internal
failure costs, disappear if no defects exist.
Exhibit 13.12 summarizes the four quality cost categories and lists specific examples of
costs. Each of the costs could have been expressed as the cost of quality-related activities, such as
the cost of certifying vendors, inspecting incoming materials, or adjusting complaints.

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 Chapter 13 Emerging Topics in Managerial Accounting 721

Exhibit 13.12
Prevention Costs Appraisal (Detection) Costs
Examples of Quality Costs by
Quality engineering Inspection of materials Category
Quality training Packaging inspection
Recruiting Product acceptance
Quality audits Process acceptance
Design reviews Field testing
Quality circles Continuing supplier verification
Marketing research
Prototype inspection
Vendor certification

Internal Failure Costs External Failure Costs

Scrap Lost sales (performance-related)

Rework Returns/allowances
Downtime (defect-related) Warranties
Reinspection Discounts due to defects
Retesting Product liability
Design changes Complaint adjustment
Repairs Recalls

Reporting Quality Costs

Improving quality can increase firm value because it increases a firm’s profitability.
Improving quality can increase profitability in at least two ways: (1) by increasing custom-
Here’s Why It’s important
er demand and (2) by decreasing the costs of providing goods and services. A quality cost
reporting system is essential to an organization serious about improving and controlling
quality costs. The first and simplest step in creating such a system is assessing current actual
quality costs. A detailed listing of actual quality costs by category can provide two import-
ant insights. First, it reveals the magnitude of the quality costs in each category, allowing
managers to assess their financial impact. Second, it shows the distribution of quality costs
by category, allowing managers to assess the relative importance of each category. When
quality costs reach the optimal range of 2 to 4% of sales, control costs typically account for
about 80 to 85% of total quality costs.
Example 13.2 illustrates a quality cost report for Auger Company.

EXAMPLE 13.2
Auger Company had total sales of $10,000,000 for the fiscal year ending on December 31,
20X1. Auger’s costs of quality are as follows: How to Prepare a
Recalls $500,000 Quality Cost Report
Scrap 350,000
Quality engineering 90,0000
Reinspection 250,000
Quality training 10,000
Product acceptance 120,000
Materials inspection 80,000
Product liability 600,000
(Continued )

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722 Chapter 13 Emerging Topics in Managerial Accounting

EXAMPLE 13.2
Required:
(Continued ) 1. Prepare a quality cost report, classifying costs by category and expressing each category
as a percentage of sales. What message does the cost report provide?
2. Prepare a bar graph and pie chart that illustrate each category’s relative contribution to
total quality costs. Comment on the significance of the distribution.
Solution:
1.

Auger Company
Quality Cost Report
For the Year Ended December 31, 20X1
Quality Costs Percentage of Salesa
Prevention costs:
Quality training $ 10,000
Quality engineering 90,000 $ 100,000 1.00%
Appraisal costs:
Materials inspection $ 80,000
Product acceptance 120,000 200,000 2.00
Internal failure costs:
Scrap $350,000
Reinspection 250,000 600,000 6.00
External failure costs:
Recalls $500,000
Product liability 600,000 1,100,000 11.00
Total quality costs $2,000,000 20.00%b
a
Actual sales of $10,000,000.
b
$2,000,000/$10,000,000 = 20%

The report clearly indicates that quality costs are too high, as 20% of sales is much
greater than the desired 2 to 4% of sales that prevails for companies with good quality
performance.
2. See Exhibit 13.13. The graphs reveal that failure costs are 85% of the total quality costs,
suggesting that Auger needs to invest more in control activities to drive down failure
costs.

The financial significance of quality costs can be assessed more easily by expressing
these costs as a percentage of actual sales. The quality cost report in Example 13.2 reports
Auger Company’s quality costs as representing 20% of sales for fiscal year 20X1. Given
the rule of thumb that quality costs should be no more than about 2 to 4% of sales, Auger
Company has ample opportunity to improve profits by decreasing quality costs through
improving quality. The quality cost report encourages managers to identify the various
costs that should appear in a performance report, to identify the current quality perfor-
mance level of the organization, and to begin thinking about the level of quality perfor-
mance that should be achieved.

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 Chapter 13 Emerging Topics in Managerial Accounting 723

60.00% Exhibit 13.13

Percentage of Total Quality Costs Quality Cost Categories: Relative
50.00% 55.00% Contribution by Category

40.00%

30.00%
30.00%
20.00%

10.00%
10.00%
5.00%
0.00%
Prevention Appraisal Internal Failure External Failure

Percentage of Total Quality Costs

5.00%

10.00%
Prevention
Appraisal
Inernal Failure
55.00% 30.00%
External Failure

Here’s How It’s Used: AT A L C O A

In 2011, an executive leadership team of Alcoa Power and shop-floor interviews were done, and brainstorming sessions
Propulsion (APP), a unit of Alcoa, Inc., decided to take held. Potential solutions were identified and then implemented
steps to improve product quality, reduce waste, and decrease using a three-stage plan: first, the process improvements were
costs. The business unit was experiencing a high incidence of implemented in a pilot plant; and then in fast-follower plants;
scrap, rework, and returns (internal and external failure costs). finally, they were extended to the broader business unit.
Customer satisfaction was low as indicated through customer Quality audits and management reviews were used to ensure
satisfaction surveys (60% of respondents held an unfavorable process improvement sustainability.
or neutral view of the unit). Thus, by using prevention activities such as process
The initial focus was on the nine foundries that had the management, quality audits, and management reviews, APP
highest scrap rates. The strategy was to develop a sustainable was able to significantly reduce scrap, rework, and returns. APP
and continuous process improvement approach that would easily exceeded the initial goal of reducing scrap by 10% per
achieve the desired improvement goals (e.g., a 10% annual year and saved more than $20 million from improvements in
reduction in scrap). Processes were studied and analyzed to the wax, shell, and cast operations. For example, a subprocess
determine which ones offered the greatest potential for savings. of one plant’s cast operation reduced scrap and
It was determined that the wax, shell, and cast manufacturing rework costs by more than 30%, which saved
operations had the most potential savings. These processes $750,000 per year.12 CONCEPT CLIP

were then mapped, benchmarking studies were performed,

12 Janet Jacobsen, “Process Management Approach Reduces Scrap, Saves Alcoa Millions,” Making the Case for Quality
(May 2016): 1–5.

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724 Chapter 13 Emerging Topics in Managerial Accounting

Controlling Quality Costs

Improving quality and reducing quality costs require that quality costs be reported and con-
trolled. Control enables managers to compare actual outcomes with standard outcomes to
gauge performance and take any necessary corrective actions. Performance reports are essential
to quality improvement programs. Quality performance reports measure the progress realized
by an organization’s quality improvement program. Two types of quality performance reports
are useful:
1. Progress with respect to a current-period standard or goal (an interim standard report)
2. The progress trend since the inception of the quality improvement program (a multiple-
period trend report)

Here’s Why It’s important Interim Standard Reports Identifying the quality standard is a key element in a quali-
ty performance report. The standard should emphasize cost reduction opportunities. Interim
quality standards express quality goals for the year. The organization must establish an inter-
im quality standard each year and make plans to achieve this targeted level. Often, the interim
quality standard is simply the quality costs incurred in the previous year, adjusted for reductions
expected from planned quality improvements. Since quality costs are a measure of quality, the
targeted level can be expressed in dollars budgeted for each category of quality costs and for
each cost item within the category. At the end of the period, the interim quality performance
report compares the actual quality costs for the period with the budgeted costs. This report
measures the progress achieved within the period relative to the planned level of progress for
that period. Example 13.3 illustrates such a report.

EXAMPLE 13.3
The actual quality costs of Auger Company, for the years ended December 31, 20X1 and
20X2, are provided below.
How to Prepare
an Interim Quality 20X1 20X2
Performance Report Prevention costs:
Quality training $ 10,000 $ 12,000
Quality engineering 90,000 108,000
Appraisal costs:
Materials inspection 80,000 98,000
Process acceptance 120,000 145,000
Internal failure costs:
Scrap 350,000 294,000
Reinspection 250,000 203,000
External failure costs:
Recalls 500,000 410,000
Product liability 600,000 530,000

At the end of 20X1, management decided to increase its investment in control costs by 20%
for each category’s items, with the expectation that failure costs would decrease by 20% for
each item of the failure categories. Sales were $10,000,000 for both 20X1 and 20X2.
Required:
1. Calculate the budgeted costs for 20X2, and prepare an interim quality performance
report.
2. Comment on the significance of the report. How much progress has Auger made?

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 Chapter 13 Emerging Topics in Managerial Accounting 725

EXAMPLE 13.3
Solution:
1.
(Continued )
Auger Company
Interim Standard Performance Report: Quality Costs
For the Year Ended June 30, 20X2
Actual Budgeted
Costs Costs Variance
Prevention costs:
Quality training $ 12,000 $ 12,000a $ 0
Quality engineering 108,000 108,000a 0
Total prevention costs $ 120,000 $ 120,000 $ 0
Appraisal costs:
Materials inspection $ 98,000 $ 96,000a $ 2,000 U
Process acceptance 145,000 144,000a 1,000 U
Total appraisal costs $243,000 $ 240,000 $ 3,000 U
Internal failure costs:
Scrap $ 294,000 $ 280,000b $ 14,000 U
Reinspection 203,000 200,000b 3,000 U
Total internal failure costs $ 497,000 $ 480,000 $ 17,000 U
External failure costs:
Recalls $ 530,000 $ 480,000b $ 50,000 U
Product liability 410,000 400,000b 10,000 U
Total external failure costs $ 940,000 $ 880,000 $ 60,000 U
Total quality costs $1,800,000 $1,720,000 $ 80,000 U
Percentage of sales 18.0% 17.2% 0.8% U
a
20X1 actual control cost × 1.20 (e.g., quality training = $10,000 × 1.20 = $12,000)
b
20X1 actual failure cost × 0.80 (e.g., scrap = $350,000 × 0.80 = $280,000)

2. Auger has come close to meeting the planned outcomes. Quality costs dropped
from 20% of sales to 18.0%, falling 0.8% short of the expected percentage.
Management’s belief that investing an additional 20% in control costs would
produce a 20% reduction in failure costs was somewhat overstated, but the overall
outcome is good.

Multiple-Period Trend Reports The interim quality report provides management

with information concerning the within-period progress measured relative to specific goals.
Here’s Why It’s important
Also useful is a picture of how the quality improvement program has been doing since its
inception. Is the multiple-period trend—the overall change in quality costs—moving in the
right direction? Are significant quality gains being made each period? Answers to these ques-
tions can be given by providing a chart or graph that tracks the change in quality from the
beginning of the program to the present. Such a graph is called a multiple-period quality
trend report. Trend in quality costs as a percentage of sales reveals the effects of quality
improvement initiatives over time. Expressing these trends by quality cost category provides
insight concerning the effect of quality improvement initiatives on the relative distribution
of quality costs.
Example 13.4 provides a detailed example of multiple-period trend reporting.

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726 Chapter 13 Emerging Topics in Managerial Accounting

EXAMPLE 13.4
Assume that Auger Company has experienced the following:

How to Prepare Multiple- Year Quality Costs Actual Sales Costs as a Percentage of Sales
Period Quality Trend 20X1 $2,000,000 $10,000,000 20.0%
Reports 20X2 1,800,000 10,000,000 18.0
20X3 1,680,000 12,000,000 14.0
20X4 1,440,000 12,000,000 12.0
20X5 1,400,000 14,000,000 10.0

By cost category as a percentage of sales for the same period of time:

Year Prevention Appraisal Internal Failure External Failure

20X1 1.00% 2.00% 6.00% 11.00%
20X2 1.20 2.43 4.97 8.60
20X3 3.00 3.00 3.00 5.00
20X4 4.00 3.00 2.50 2.50
20X5 4.50 1.25 2.25 2.00

Required:
1. Prepare a bar graph that reveals the trend in quality cost as a percentage of cost (time
on the horizontal axis and percentages on the vertical axis). Comment on the message
of the graph.
2. Prepare a bar graph for each cost category as a percentage of sales. What does this
graph tell you?
Solution:
1. See Exhibit 13.14. From Exhibit 13.14, it is clear that there has been a steady
downward trend in quality costs as a percentage of sales (dropping from 20 to 10%).
The graph also reveals that there is still ample room for improvement.
2. See Exhibit 13.15. From Exhibit 13.15, we can see that Auger has had dramatic
success in reducing internal and external failure costs. More money is being spent on
prevention. Also, appraisal costs have increased and then decreased, suggesting that
Auger is becoming more confident in its prevention initiatives.

Exhibit 13.14 25.0%

Multiple-Period Trend Graph: Total
Quality Costs
20.0%
Percentage of Sales

20.0%
18.0%
15.0%
14.0%
10.0% 12.0%
10.0%

5.0%

0.0%
20X1 20X2 20X3 20X4 20X5
Year

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 Chapter 13 Emerging Topics in Managerial Accounting 727

Exhibit 13.15
12.00%
Multiple-Period Trend Graph:
Individual Quality Cost Categories
10.00%
Percentaage of Sales

8.00% Prevention
Appraisal
6.00%
Internal failure

4.00% External Failure

2.00%

0.00%
20X1 20X2 20X3 20X4 20X5
Year

Check Point
1. Which of the following is an internal failure cost?
a. Training production worker in new quality procedures
b. Sampling a batch of goods to determine if the batch has an acceptable defect
rate
c. Processing and responding to customer complaints
d. Retesting a reworked product
Answer:
d. Internal failure is the cost incurred when a defective product is discovered prior to an
external sale.
2. What purposes are served by preparing a quality cost report?
Answer:
A quality cost report reveals the magnitude of quality costs and also shows the relative
distribution of the quality cost categories. The relative distribution allows the manager
to assess the importance of the various categories and to determine where quality
improvement emphasis is needed.

LEAN MANUFACTURING AND LEAN OB J ECT I VE ◀ 4

Describe the basics of lean
ACCOUNTING manufacturing and lean accounting.

Lean manufacturing is concerned with eliminating waste in manufacturing processes. Promised

benefits include such outcomes as reduced lead times, improved quality, improved on-time de-
liveries, less inventory, less space, less human effort, lower costs, and increased profitability. Lean
accounting is a simplified approach to costing that supports lean manufacturing with both finan-
cial and nonfinancial measures.

Lean Manufacturing
Lean manufacturing is an approach designed to eliminate waste and maximize customer value.
It is characterized by delivering the right product, in the right quantity, with the right quality

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728 Chapter 13 Emerging Topics in Managerial Accounting

(zero defects), at the exact time the customer needs it, and at the lowest possible cost. These lean
objectives are achieved by following five principles of lean thinking:13
• Precisely specify value by each particular product.
• Identify the “value stream” for each.
• Make value flow without interruption.
• Let the customer pull value from the producer.
• Pursue perfection.

Value by Product Value is determined by the customer. Customer value is the difference
between realization and sacrifice. Realization is what a customer receives. Sacrifice is what a
customer gives up, including what they are willing to pay for the basic and special product fea-
tures, quality, brand name, and reputation. Adding features and functions that are not wanted
by customers is a waste of time and resources. Furthermore, attempting to market features and
products that customers don’t want is a waste of time and resources.

Value Stream The value stream is made up of all processes that a product must pass through,
from the initial customer order to the delivery to the customer. The most common value stream
is called the order fulfillment value stream. The order fulfillment value stream focuses on pro-
viding current products to current customers. A value stream reflects all that is done—both
good and bad—to bring the product to a customer. Thus, analyzing the value stream, called
value-stream mapping, allows management to identify waste. Activities within the value stream
are value-added or nonvalue-added. Nonvalue-added activities are the source of waste. They are
of two types: (1) activities avoidable in the short run and (2) activities unavoidable in the short
run due to current technology or production methods. The first type is most quickly eliminated,
while the second type requires more time and effort. Exhibit 13.16 visually portrays an order
fulfillment value stream. This particular value stream only has one manufacturing cell. Other
value streams may have several cells.

Exhibit 13.16
Order Fulfillment Value Stream Sales Order Entry Scheduling Purchasing

Packaging Cellular Support Production

and Shipping Manufacturing Activities Planning

Collecting
Billing Post-Sales
Cash and
Customer Services
Receivables

A value stream may be created for every product; however, it is more common to group
products that use common processes into the same value stream (families of similar products).
Once value streams are identified, then the next step is to assign people and resources to the
value streams. As much as possible, the people, the machines, the manufacturing processes, and
the support activities need to be dedicated to the value streams. This allows a sense of ownership
and provides a means of direct accountability. It also simplifies and facilitates product costing.
In a sense, the value stream is its own independent company, a factory within a factory, and the
value-stream team is responsible for its improvement, growth, and profitability.

13 James Womack and Daniel Jones, Lean Thinking (New York: Free Press, 2003).

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 Chapter 13 Emerging Topics in Managerial Accounting 729

Value Flow In a traditional manufacturing setup, production is organized by function into

departments and products are produced in large batches, moving from department to depart-
ment. There is significant move time and wait time as each batch moves from one department
to another and waits for its turn if there is a batch in process in front of it. Batches must wait
for a preceding batch and a subsequent setup before beginning a process. Once a batch starts a
process, units are processed sequentially. As units are finished, they must wait for other units in
the batch to be finished before the entire batch moves to the next process. Thus, there is pre-
process waiting and post-process waiting. Exhibit 13.17 illustrates a traditional batch produc-
tion process, with the presence of both wait and move times.

6 minutes 5 minutes Exhibit 13.17

Wait time = 8 minutes Move and wait time = 9 minutes Drilling and Traditional Batch Production
Cutting Process
Insertion

Move and wait time = 16 minutes

5 minutes 4 minutes
Move and wait time = 12 minutes
Assembly Finishing

Color Code:
Red = Nonvalue-added move and pre-process wait time
Green = Value-added process time

Reduced Setup/Changeover Times Lean manufacturing reduces wait and move times dra-
matically and allows the production of small batches (low volume) of differing products (high
variety). The key factors in achieving these outcomes are lower setup times and cellular man-
ufacturing. Reducing the time to configure equipment to produce a different type of product
enables smaller batches in greater variety to be produced. It also decreases the time it takes to
produce a unit of output, thus increasing the ability to respond to customer demand. Customers
do not value changeover and therefore it represents waste. While reducing setup times is im-
portant, even more critical is the use of cellular or continuous flow manufacturing.

Cellular Manufacturing Lean manufacturing uses a series of cells to produce families of

similar products. A lean manufacturing system replaces the traditional plant layout with a pat-
tern of manufacturing cells. Cell structure is chosen over departmental structure because it
reduces lead time, decreases product cost, improves quality, and increases on-time delivery.
Here’s Why It’s important
Manufacturing cells contain all the operations in close proximity that are needed to produce
a family of products. The machines used are typically grouped in a semicircle. The reason for
locating processes close to one another is to minimize move time and to keep a continuous flow
between operations while maintaining zero inventory between any two operations. The cell is
usually dedicated to producing products that require similar operations. Exhibit 13.18 shows a
proposed cellular manufacturing structure. Notice that by grouping processes closely together
and dedicating the cell to a family of products, the move and wait times are essentially elimi-
nated. Example 13.18 illustrates the value of cellular manufacturing relative to the traditional
departmental approach.

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730 Chapter 13 Emerging Topics in Managerial Accounting

Exhibit 13.18 6 minutes 5 minutes

Proposed Manufacturing Cell Drilling and
Cutting
Insertion

Finishing Assembly

4 minutes 5 minutes

EXAMPLE 13.5
See Exhibits 13.17 and 13.18.

How to Calculate Required:

Production Time for 1. Using Exhibit 13.17, calculate the total time it takes to produce a batch of 12 units,
using the traditional departmental structure.
Traditional and Cellular
Manufacturing 2. Now refer to Exhibit 13.18. With cellular manufacturing, how much time is saved
producing the same batch of 12 units? Assuming the cell operates continuously, what is
the production rate? Which process controls this production rate?
3. If the processing time of machining is reduced from 6 to 5 minutes, what is the
production rate now, and how long will it take to produce a batch of 12 units?
Solution:
1. Total lead time for a batch of 12 units:
Processing time
Cutting 72 minutes
Drilling and insertion 60 minutes
Assembly 60 minutes
Finishing 48 minutes
Total processing 240 minutes
Move and wait times 45 minutes
Total batch time 285 minutes

2.
Processing time (12 units):
First unit 20 minutes
Second unit 26 minutes (processing begins 6 minutes after the first)
Twelfth unit 86 minutes (total processing time)
Time saved over traditional manufacturing: 240 minutes – 86 minutes = 154 minutes

If the cell is processing continuously, then a unit is produced every 6 minutes after the
start-up unit. Thus, the production rate is 10 units per hour (60/6). The bottleneck
process (the one with the longest per-unit processing time) controls the production rate.
3. Five minutes is now the longest per-unit processing time, and so the production rate is
60/5 = 12 units per hour. Producing 12 units will take 60 minutes.

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 Chapter 13 Emerging Topics in Managerial Accounting 731

Pull Value Many firms produce for inventory and then try to sell the excess goods they have
produced (demand-push system). Efforts are made to create demand for the excess goods—
goods that customers probably may not even want. Lean manufacturing uses a demand-pull
system. Lean manufacturing eliminates waste by producing a product only when it is needed
and only in the quantities demanded by customers. Demand pulls products through the man-
ufacturing process. Each operation produces only what is necessary to satisfy the demand of
the succeeding operation. Low setup times and cellular manufacturing are the major enabling
factors for producing on demand.
A companion to a demand-pull system is JIT purchasing. JIT purchasing requires suppliers
to deliver parts and materials just in time to be used in production, eliminating the need for
materials inventories. Supply of parts must be linked to production, which is linked to demand.
Lean manufacturers emphasize long-term contracts with suppliers that stipulate prices and ac-
ceptable quality levels.

Pursue Perfection Zero setup times, zero defects, zero inventories, zero waste, producing on
demand, increasing a cell’s production rates, minimizing cost, and maximizing customer value
represent ideal outcomes that a lean manufacturer seeks. As the process of becoming lean begins
to unfold and improvements are realized, the possibility of achieving perfection becomes more
believable. The relentless and continuous pursuit of these ideals is fundamental to lean manufac-
turing. As production flow increases and processes begin to improve, more hidden waste tends
to be exposed. The objective is to produce the highest-quality, lowest-cost products in the least
amount of time.

Lean Accounting
Lean manufacturing changes structural and procedural activities, and these changes, in turn,
lead to changes in traditional cost management practices. In fact, traditional costing and op-
erational control approaches like standard costing and departmental budgetary variances may
encourage overproduction and work against the demand-pull system needed in lean manufac-
turing. Furthermore, distorted product costs can signal failure for lean manufacturing, even
when significant improvements may be occurring. To avoid obstacles and false signals, chang-
es in both product-costing and operational control approaches are needed when moving to a
value-stream-based lean manufacturing system.14

Focused Value Streams and Traceability of Overhead Costs Creating a value

stream for every product within a plant (focused value streams) means that many overhead
costs previously assigned to products using either driver tracing or allocation are now directly
traceable to products. For example, equipment in a focused value stream is now dedicated
to the production of a single product. In this case, depreciation is now a directly traceable
product cost. The same is true of other resources such as multiskilled workers, decentral-
ized services, and workers with specialized skills (e.g., industrial engineers and production
schedulers). Typically, implementing the value-stream structure does not require an increase
in the number of people needed. Lean manufacturing eliminates wasteful activities, reduc-
ing the demand for people. For example, when production planning is reduced significantly
because of an efficiently functioning demand-pull system, some of those working in produc-
tion planning can be cross-trained to perform value-added activities within the value stream,
such as purchasing and quality control. Exhibit 13.19 is a visual summary of value-stream cost
assignments.

14 Much of the material on lean accounting is based on two sources: Frances A. Kennedy and Jim Huntzinger, “Lean
Accounting: Measuring and Managing the Value Stream,” Cost Management (September/October 2005): 31–38, and
Brian Maskell and Bruce Baggaley, Practical Lean Accounting (New York: Productivity Press, 2004).

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732 Chapter 13 Emerging Topics in Managerial Accounting

Exhibit 13.19
Production Operational
Value-Stream Cost Assignments Equipment Facilities
Support Support

Value Stream

Direct
Cell Labor Maintenance Other
Materials

As Exhibit 13.19 shows, most costs are assigned directly to the value stream; however, some
costs such as facility costs are assigned to each value stream using cost drivers. Facility costs are
assigned using a cost per square foot (total cost/total square feet). If a value stream uses less
square feet, it receives less cost. Thus, the purpose of this assignment is to motivate value-stream
managers to find ways to occupy less space. As space is made available, it can be used for new
product lines or to accommodate increased sales. For example, suppose that the facility costs
are $450,000 per year for a plant occupying 30,000 square feet. The cost per square foot is $15.
A value stream occupying 10,000 square feet would be assigned a cost of $150,000. If the
value-stream manager figures out how to do the same tasks with 5,000 square feet, the cost
would be reduced to $75,000. Any unabsorbed facility cost would be deducted from revenue
as a separate item.

Limitations Initially, it may not be possible to assign all the people needed exclusively to a
value stream. There may be some individuals working in more than one value stream. The cost
of these shared workers can be assigned to individual value streams in proportion to the time
spent in each stream. It is also true that even in the most ideal circumstances, some individuals
will remain outside any particular value stream (the plant manager, for example). However, with
multiple value streams, the unassigned costs are likely to be a very small percentage of the total
costs. Finally, in reality, having a value stream for every product is not practical. The usual prac-
tice is to organize value streams around a family of products.

Value-Stream Costing
Here’s Why It’s important Product Costing: Single-product (Focused) Value Stream In a focused value stream, all
value-stream costs belong exclusively to the product that the stream produces and, therefore, are
assigned to a product using direct tracing. Value streams increase the number of directly trace-
able costs and therefore increase the accuracy of product costing. Focused value streams provide
simple and accurate product costing. Typically, unit costs are calculated weekly and are based on
actual costs, using the following formula:

Value-Stream Product Cost = Total Actual Value-Stream Costs/Units Shipped

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 Chapter 13 Emerging Topics in Managerial Accounting 733

Using units shipped in the unit cost calculation instead of units produced motivates man-
agers to reduce inventories. If more units are shipped than produced, then the weekly unit cost
will decrease and inventories will reduce. If more is produced than shipped, then the unit cost
will increase (because the production costs of the units produced and not shipped are added to
the numerator), creating a disincentive to produce for inventory.

Product Costing: Multiple-Product Value Stream Many value streams are formed around
products with common processes. Manufacturing cells within a value stream are thus structured
Here’s Why It’s important
to make a family of products or parts that require the same manufacturing sequence. The weekly
unit product cost for multiple-product value streams is the sum of each unit’s materials cost and
the average conversion cost:

Value-Stream Product Cost = Unit Materials Cost + Average Conversion Cost

where

Unit Materials Cost (for each product) = Actual Materials Cost/Units Shipped

Average Conversion Cost = Total Actual Conversion Costs/Units Shipped

Here’s How It’s Used: IN YOUR LIFE

Emily recently joined a large law firm fresh out of law school. would need to collect $10 ($2.80 + $7.20) from each person
She discovered that the 50 employees of the law firm eat lunch to pay for the lunch. This approach is like having one value
every Friday at a popular pizza restaurant. They eat in a separate stream with four products (four different eating patterns). The
reserved room. They are served individual bowls of salad ($2.80 cost of materials (salads in this case) is assigned directly to each
each). A two-topping pizza costs $20 and is divided into 10 product, and the average conversion cost (average pizza cost) is
slices. For drinks, the restaurant provides complimentary tea added to the direct materials cost to obtain a total product cost.
and water. Each member of the law firm has to pay an assessed Emily noted, however, that the eating patterns were quite
amount for the lunch. Since the food had to be ordered in different among the groups. For Group A, the total pizza cost
advance, the managing partner gave Emily the assignment to is simply $20 (only one pizza is needed) and the pizza cost
determine how much food to order and how much to charge per person is $2.00, which when added to the $2.80 gives
each individual of the firm for the lunch. a lunch cost of $4.80. On the other hand, for Group D, the
Emily surveyed the members of the firm and compiled the average pizza cost per person is $12, which when added to the
following table that reflected eating preferences (divided into salad cost gives a lunch cost of $14.80. Groups B and C would
four subgroups): have lunch costs of $6.80 and $10.80, respectively. Charging
by groups is more accurate. Each group would be analogous
Number in Slices per to a focused value stream.
Group Each Group Person Total Slices Another possibility for Emily is to group the employees into
A 10 1 10 a “family of products,” where employees with similar eating
B 10 2 20 habits are grouped together. Groups A and B, for example,
C 15 4 60 could form a light-eaters value stream, and Groups C and D
D 15 6 90 would form a heavy-eaters value stream. The light-eaters lunch
Totals 50 N/A 180 cost would be $5.80 ($2.80 for salad plus an average pizza cost
of $3.00). The heavy-eaters lunch cost would be $12.80 each.
Based on the survey, Emily ordered 18 pizzas (180/10) and Forming value streams has a lot to do with trading
noted that the expected cost would be $360 ($20 × 18), with off complexity and accuracy. Sometimes simplicity
an average pizza cost per person of $7.20 ($360/50). Thus, she outweighs the issue of accuracy. CONCEPT CLIP

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734 Chapter 13 Emerging Topics in Managerial Accounting

The materials costs are assigned accurately as they are directly traced to each product.
However, all products in the value stream receive the same average conversion cost per unit.
The accuracy of the resulting average conversion cost depends on how homogeneous the
products are. If they are very similar, then using the average conversion cost will approximate
quite closely the individual product cost. Using the average conversion cost is useful provided
the products are similar and consume resources in approximately the same proportions. If
products are quite similar, the resulting product cost will approximate the individual product
costs. Furthermore, if the product mix is stable, then the trend in the average product cost
over time is a reasonable measure of changes in economic efficiency. If, however, the products
are heterogeneous or reflect a great deal of variety through custom designing, then using av-
erage conversion cost is not a good measure for tracking changes in value-stream efficiency.
Also, there is no clear indication of what the cost of individual products is. In this case, other
product cost calculation approaches are needed—approaches that provide a much better level
of accuracy.

Features and Characteristics Costing An approach called features and characteristics

costing is recommended (albeit reluctantly) by those advocating the simple average cost-
ing approach. This approach recognizes that some product components take more effort
(time) to make than others and thus cost more. Differences in features and characteristics
cause cost differences. An adjustment is made to the average product cost that reflects this
complexity difference. Value streams with heterogeneous products find themselves in the
same cost-distortion dilemma as plants with multiple products and plantwide overhead
rates. ABC solves the distortion problem using causal tracing. ABC could, of course, be
used within a value stream; however, the argument is that ABC is too complex and too data
intensive for a lean setting. Yet, there is no compelling evidence that features and character-
istics costing provides simplicity with accuracy. A relatively new costing approach, called
duration-based costing seems to offer both simplicity and accuracy and, thus, may be well
suited for multiple-product value streams.

Duration-Based Costing Duration-based costing (DBC) uses a single rate to assign con-
Here’s Why It’s important version costs and approximates a comprehensive ABC system based in duration drivers.15 To
apply DBC to a value stream, first calculate a weekly value-stream conversion cost rate as
follows:

Conversion Cost Rate = Total Actual Conversion Costs/Total Net Production Hours

The net total production hours are the total hours available for work of all primary activities (ac-
tivities consumed by products) whether the activities are value- or nonvalue-added. Net hours
mean that such things as break times and expected stoppages are excluded and thus correspond
to the practical capacity for each activity. Once the rate is calculated, the unit conversion cost is
calculated by multiplying the rate by the cycle time for each product:

Conversion Cost per Unit = Conversion Cost Rate × Cycle Time

Cycle time is the time that a unit of product spends in the value stream, from start to finish. It
is not the same as the production rate.
The actual costs and production hours for a value stream with two products in Holland
Company are shown in Exhibit 13.20 for the week ending October 8. Using this information,
Example 13.6 illustrates product costing for single- and multiple-product value streams.

15 Adapted from the methodology described in Anne-Marie T. Lelkes and Donald R. Deis, “Using the Production Cycle
Time to Reduce the Complexity of ABC,” Journal of Theoretical Accounting Research, Vol. 9, Issue 1 (Fall 2013): 57–84.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
 Chapter 13 Emerging Topics in Managerial Accounting 735

Exhibit 13.20 Value-Stream Costs and Production Hours: Models X12 and Y35

Holland Company
This Week, October 8

Net Hours Materials Salaries/Wages Machining Other Total Cost

Order processing 800 $ 18,000 $ 18,000

Production planning 50 2,000 2,000
Purchasing 400 11,000 11,000
Cutting 1,000 $100,000 37,500 $36,000 $18,000 191,500
Welding and drilling 1,200 50,000 42,000 42,000 12,000 146,000
Assembly 250 75,000 25,000 10,000 15,000 125,000
Testing 300 8,500 2,000 10,500
Packaging and shipping 300 9,000 9,000
Invoicing 700 12,000 12,000
Totals 5,000 $225,000 $165,000 $88,000 $47,000 $525,000

EXAMPLE 13.6
See Exhibit 13.20. During the week of October 8, Holland Company produced and shipped
2,000 units of Model X12 and 8,000 units of Model Y35, for a total of 10,000 units. Model How to Calculate
X12 has a cycle time of 1.04 hours, and Model Y35 has a cycle time of 0.34 hour.
Value-Stream Product
Required: Costs
1. Assume that the value-stream costs and total units shipped apply only to one model
(a single-product value stream). Calculate the unit cost, and comment on its accuracy.
2. Assume that Model X12 is responsible for 50% of the materials cost. Calculate the unit
cost for Models X12 and Y35, and comment on its accuracy. Explain the rationale for
using units shipped instead of units produced in the calculation.
3. Calculate the unit cost for the two models, using DBC. Explain when and why this
cost is more accurate than the unit cost calculated in Requirement 2.
Solution:
1. Unit cost = $525,000/10,000 = $52.50 per unit. The cost is very accurate, as the value
stream is dedicated to one product and its costs all belong to that product.
2. First, the unit materials cost is calculated separately:
Model X12: $112,500*/2,000 = $56.25
Model Y35: $112,500/8,000 = $14.06
*50% × $225,000
Next, the average unit conversion cost is calculated: $300,000*/10,000 = $30.
*Conversion Cost = Total Cost — Materials Cost
= $525,000 — $225,000 = $300,000
Finally, the unit cost is computed (sum of materials and average conversion cost):
Model X12: $56.25 + $30 = $86.25
Model Y35: $14.06 + $30 = $44.06
The accuracy of the unit cost depends on the accuracy of the average unit conversion
cost, which depends on the homogeneity of the products within the value stream.
Using units shipped for the unit calculation motivates managers to reduce
inventories.
(Continued )

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736 Chapter 13 Emerging Topics in Managerial Accounting

EXAMPLE 13.6
3. First, calculate the conversion cost rate:
(Continued ) Conversion Cost Rate = Conversion Cost/Total Net Production Hours
= $300,000/5,000
= $60 per hour
Next, calculate the unit conversion cost for each product:
Conversion Cost per Unit = Conversion Rate × Cycle Time
Model X12: $60 × 1.04 = $62.40
Model Y35: $60 × 0.34 = $20.40
Finally, add the unit materials cost:
Model X12 = $56.25 + $62.40 = $118.65
Model Y35 = $14.06 + $20.40 = $34.46
DBC should be used if the products are not homogeneous products. It is more
accurate, as it approximates ABC assignments.

Value-Stream Operational Control

The lean control system replaces the traditional standard costing approach with a Box Scorecard
that compares operational, capacity, and financial metrics with prior week performances and
with a future desired state. Trends over time and the expectation of achieving some desired state
in the near future are the means used to motivate constant performance improvement. Thus,
the lean control uses a mixture of financial and nonfinancial measures for the value stream. The
future desired state reflects targets for the various measures. Operational, nonfinancial measures
are also used at the cell level. A typical value-stream Box Scorecard is shown in Exhibit 13.21
(metrics and format can vary).

Exhibit 13.21
For 10/8/20X1 This Week Planned Future State
Holland Company Value-Stream Last Week (10/8/20X1) (01/31/20X2)
Box Scorecard
Operational
Units sold per person 500 520 540
On-time delivery 88% 90% 95%
Dock-to-dock days 19.5 19.0 17.0
First-time through 65% 75% 85%
Average product cost $55.00 $52.50 $50.00
Accounts receivable days 28 27 26

Capacity
Productive 31% 35% 37%
Nonproductive 45% 40% 35%
Available 24% 25% 28%

Financial
Weekly sales $950,000 $875,000 $1,250,000
Weekly material cost $250,000 $225,000 $310,000
Weekly conversion cost $396,000 $300,000 $365,000
Weekly value-stream profit $304,000 $325,000 $625,000
ROS 32% 40% 46%

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 Chapter 13 Emerging Topics in Managerial Accounting 737

For the operational measures, units sold per person is a partial labor productivity measure
and is therefore a measure of labor efficiency. Dock-to-dock days is the time it takes for a prod-
uct to be manufactured from the moment the materials arrive at the receiving dock until the
finished product is shipped from the shipping dock and thus includes wait time and inven-
tory time. First-time through is a measure of quality and is simply the percentage of product
that made it through production without being defective and thus needing to be rejected or
reworked. For multiple-product value streams, average product cost may be supplemented (or
perhaps replaced) with individual product cost information. Capacity is labeled as productive
(value-added), nonproductive (nonvalue-added—used but wasteful), and available (unused).
The financial measures are also important and are self-explanatory.
The scorecard measures are expected to improve over time and to be helpful in managing
and bringing about improvement. For example, from the Box Scorecard in Exhibit 13.21, we
see that the nonproductive capacity is targeted to go from 45% (current state) to 35% (future
state), with productive capacity increasing from 31 to 37% and available capacity increasing
from 24 to 28%. As waste is eliminated, the nonproductive capacity converts into available ca-
pacity. The machines, people, and other resources used for wasteful activities are now available
for more productive work. For financial performance to improve, some decisions must be made
with respect to the increase in available capacity. The most sensible and practical approach is
to commit to use the freed-up resources to expand the business. One possibility is to add new
product lines. Another possibility is to transfer the resources to other value streams that are
in a high-growth state with increasing resource demands. Another is to realize cost reductions
by reducing headcount and eliminating resources. This latter approach is the least desirable. It
makes it hard to gain the cooperation and involvement of employees with the transformation
into a lean workforce if their suggestions and actions are going to lead to the loss of their jobs or
the jobs of their friends and coworkers.

Check Point
1. A manufacturing cell within a value stream is structured with four processes and
associated unit processing times:
Molding: 7 minutes
Grinding: 15 minutes
Polishing: 4 minutes
Finishing: 2 minutes
How many units can the cell produce per hour on a continuous running basis
(production rate)?
Answer:
Using the bottleneck process (Grinding), the production rate is 4 units per hour
(60/15).
2. Suppose a value stream has two products with materials costs of $20,000 and
$60,000, respectively, for a given week. The conversion costs for the week are
$120,000. The units produced for the first product are 11,000, with 10,000
shipped to customers. For the second product, 20,000 units were produced and
shipped. What is the cost per unit for the first product?
Answer:
Unit Cost = Unit Materials Cost + Average Unit Conversion Cost
= $20,000/10,000 units shipped + ($120,000/30,000 units shipped)
= $2.00 + $4.00 = $6.00 per unit

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738 Chapter 13 Emerging Topics in Managerial Accounting

O BJE C T I V E 5 ▶
INTERNATIONAL ISSUES IN MANAGEMENT
Explain the role of the management
accountant in the international
ACCOUNTING
environment.
In an increasingly global economy, the management accountant provides crucial financial and
business expertise. Good training, education, and staying abreast of changes in one’s field are
important to any accountant. However, the job of the management accountant in the inter-
national firm is made more challenging by the ambiguous and ever-changing nature of global
business. Since much of the management accountant’s job is to provide relevant information to
management, staying up to date requires reading books and articles in a variety of business areas,
including information systems, marketing, management, politics, and economics. In addition,
the management accountant must be familiar with the financial accounting rules of the coun-
tries in which the firm operates.

Types of Involvement in the International Economy

Companies can participate in the international environment in a number of ways. Some of
the choices are importing and exporting, wholly owned subsidiaries, joint ventures, and the
Here’s Why It’s important multinational corporation (MNC). Each of these offers both costs and benefits for the
company and the management accountant must be aware of them in order to help decision
makers determine which, if any, involvement in international trade is best.

Importing and Exporting A relatively simple form of multinational involvement is im-

porting and exporting. Even such simple transactions as importing and exporting can present
new risks and opportunities for companies. A company may import materials for use in produc-
tion. While this transaction may seem identical to the purchase of materials from domestic sup-
pliers, U.S. tariffs add complexity and cost. In accounting for materials, freight-in is a materials
cost. An imported part may have a tariff, or duty, in addition to freight-in cost. A tariff, or duty,
is a tax on imports levied by the federal government. In accounting, we treat this tax as part of
the cost of the materials. The amount of tax may be decreased sometimes if domestic content
is added (making a new product or material) or if the importation of the material occurs in a
foreign trade zone.
The U.S. government has set up foreign trade zones, which are areas near a customs port
of entry that are physically on U.S. soil but are considered to be outside U.S. commerce. San
Antonio, New Orleans, and the Port of Catoosa, Oklahoma, are examples of cities with foreign
trade zones. Some U.S. companies have set up manufacturing plants within the foreign trade
zones. Goods imported into a foreign trade zone are duty-free until they leave the zone for sale
in the United States. This has important implications for manufacturing firms that import ma-
terials. Since tariffs are not paid until the imported materials leave the zone as part of a finished
product, the company can postpone payment of duty and any associated loss of working capital.
Additionally, the company does not pay duty on defective materials or on inventory that has not
yet been included in finished products. The management accountant must be aware of the costs
of importing materials. He or she should also be able to evaluate the potential benefits of the
foreign trade zone in considering the location of satellite plants.
Let’s take a closer look at two companies. Roadrunner, Inc., operates a petrochemical plant
located in a foreign trade zone and imports volatile materials (e.g., chemicals that experience
substantial evaporation loss during processing) for use in production. Wilycoyote, Inc., operates
an identical plant just outside the foreign trade zone. Each plant imported $400,000 of crude oil
for use in chemical production. About 30% of the oil is lost through evaporation during produc-
tion. Duty is assessed at 6% of cost, and carrying cost is 12% per year. Both companies purchase
the material and process it. They sell the finished product 8 months later. What is the amount of
duty paid and carrying costs incurred for each company?
Wilycoyote pays duty, at the point of purchase, of $24,000 (0.06 × $400,000). Wilycoyote
also has carrying costs associated with the duty payment of 12% per year times the portion of

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 Chapter 13 Emerging Topics in Managerial Accounting 739

the year that the oil is in materials or finished goods inventory, in this case, 8 months. Total
duty-related carrying cost is $1,920 (0.12 × 8/12 × $24,000). Total duty and duty-related carry-
ing costs are $25,920. Roadrunner, on the other hand, pays duty at the time of sale because it is
in a foreign trade zone, and imported goods do not incur duty until (or unless) they are moved
out of the zone. Since 70% of the original imported oil remains in the final product, duty equals
$16,800 (0.70 × $400,000 × 0.06). There are no carrying costs associated with the duty. A sum-
mary of the duty-related costs for the two companies follows:

Roadrunner Wilycoyote
Duty paid at purchase $ 0 $24,000
Carrying costs of duty 0 1,920
Duty paid at sale 16,800 0
Total duty and duty-related cost $16,800 $25,920

Clearly, Roadrunner has saved $9,120 ($25,920 - $16,800) on just one purchase of imported
materials by locating in the foreign trade zone.

Exporting Exporting is the sale of a company’s products in foreign countries. However,

exporting is usually more complex than the sale of finished goods within the home country.
Foreign countries have a variety of import and tariff regulations. The job of complying with the
foreign rules and regulations often falls to the controller’s office, just as compliance with U.S. tax
regulations is an accounting function. Alternatively, a U.S. company may choose to work with
an experienced distributor familiar with the legal complexities of the other countries.
Trade treaties between countries affect the tariffs charged. For example, the North American
Free Trade Agreement (NAFTA) allows importers in the United States, Mexico, and Canada
to pay reduced tariffs on goods produced in the three countries. The Trans-Pacific Partnership
(TPP) will charge tariff rates and require member countries to adhere to regulations on human
trafficking, child labor, minimum wages, and working conditions. If Vietnam joins the TPP,
Nike will be able to import shoes without payment of tariff (currently ranging from 8 to 15%).
U.S. companies will have improved protection of intellectual property and the ability to sue in
international court if the companies feel they are treated worse than Vietnamese companies.16
Management accountants must be aware of the customs regulations and ensure that ade-
quate recordkeeping and internal control mechanisms exist.

Wholly Owned Subsidiaries A company may choose to purchase an existing foreign

company, making the purchased company a wholly owned subsidiary of the parent. This strat-
egy has the virtue of simplicity. The foreign company has established an outlet for the product
and has the production and distribution facilities already set up.
Outsourcing of technical and professional jobs is becoming an important issue for
cost-conscious U.S. firms. Outsourcing is the payment by a company for a business function
formerly done in house. For example, Levi Strauss outsourced 10 of its inventory and finan-
cial functions to Wipro, a Banglore, India, consulting firm, as part of a move designed to save
up to $200 million in costs.17
Outsourcing is done by foreign firms as well. Lexus opened its Kentucky manufacturing
plant in 2015. Building cars in the United States allows Lexus to reduce transportation costs as
well as currency conversion risk.18

16 Lydia DePillis, “How More Business with Nike Could Affect Workers in Vietnam,” The Washington Post (May 8, 2015).
Taken from [Link]
help-workers-in-vietnam/.
17 Kimberly S. Johnson, “Levi Strauss to Outsource Finance Unit,” The Wall Street Journal ( July 13, 2015). Taken from
[Link]
18 Aaron M. Kessler, “With a Hush, an American Lexus Plant Goes to Work,” New York Times (November 12, 2015).
Taken from [Link]

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740 Chapter 13 Emerging Topics in Managerial Accounting

Joint Ventures Sometimes, companies with the expertise needed by MNCs do not exist or
are not for sale. In this case, a joint venture may work. A joint venture is a type of partnership in
which investors co-own the enterprise.
Sometimes, a joint venture is required because of restrictive laws. In China, for example,
MNCs are not allowed to purchase companies or set up their own subsidiaries. Joint ventures
with Chinese firms are required. Similarly, India and Thailand demand local ownership. Loctite,
maker of Super Glue, runs joint ventures in both India and Thailand for that reason.
A special case of joint venture cooperation is the maquiladora. A maquiladora is a manu-
facturing plant, located in Mexico, that processes imported materials and reexports them to the
United States. Originally designed to encourage U.S. firms to invest in Mexico, the program has
now expanded to include other foreign firms, such as Nissan Motor and Sony. Basically, the
maquiladora enjoys special status in both Mexico, which grants operators an exemption from
Mexican laws governing foreign ownership, and the United States, which grants exemptions
from or reductions in customs duties levied on reexported goods. The structure of the maquila-
dora is flexible. Mexico permits different levels of involvement. The minimal level combines low
risk with low cost savings. In this case, the U.S. firm transfers materials to an existing Mexican firm
and imports them back in finished form. All hiring and operating of the Mexican plant is han-
dled by the Mexican owners. The highest level of involvement offers both high risk and high cost
savings. At this level, the U.S. firm owns the Mexican subsidiary and oversees all the operations.
Foreign investment has moved well beyond the border cities to a broad band of northern
Mexico. Improvements in the Mexican infrastructure (e.g., roads and communications) have
enticed companies further into the interior, lowering nonlabor costs. U.S. companies were orig-
inally drawn to the maquiladoras for the cheap labor. Now, both wage rates and other benefits
have risen.
U.S. firms have also found other benefits to investment in maquiladoras. For example, Ford’s
plant in Chihuahua was built to satisfy export requirements for doing business in Mexico. Now,
it supports Ford’s sales to Mexico, establishing a marketing reason for the plant’s presence.
No matter which structure the MNC takes, it faces issues of foreign trade. An important
issue is foreign currency exchange, which is addressed in the next section.

Foreign Currency Exchange

When a company operates only in its home country, only one currency is used, and exchange
issues never arise. However, when a company begins to operate in the international arena, it may
use foreign currencies. These foreign currencies can be exchanged for the domestic currency
using exchange rates. If the exchange rates never changed, problems would not occur. Exchange
rates do change, however, and often on a daily basis. Thus, a dollar that could be traded for 115
yen one day may be worth only 105 yen on another day. Currency rate fluctuations add consid-
erably to the uncertainty of operating in the international arena.
The management accountant plays an important role in managing the company’s expo-
sure to risk of currency fluctuations. Transaction risk refers to the possibility that future cash
transactions will be affected by changing exchange rates. Economic risk refers to the possibility
that a firm’s present value of future cash flows will be affected by exchange rate fluctuations.
Translation (or accounting) risk is the degree to which a firm’s financial statements are exposed
to exchange rate fluctuation. Let’s look more closely at these three components of currency risk
and ways in which the accountant can manage the company’s exposure to them.

Managing Transaction Risk Currencies may be traded for one another, depending on
the exchange rate in effect at the time of the trade. The spot rate is the exchange rate of one
currency for another for immediate delivery (i.e., today). For example, on June 1, 2017, the spot
rate of dollars for euros was $1 = €1.117 and of dollars for yen was $1 = ¥109.5471. You can
easily find the spot rates for any currency, using the Internet. Changes in the spot rates can affect
the value of a company’s future cash transactions, posing transaction risk. Let’s first get a feel for
currency appreciation and depreciation before we go on to exchange gains and losses.

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 Chapter 13 Emerging Topics in Managerial Accounting 741

Here’s How It’s Used: IN YOUR LIFE

Luisa has been planning all year to spend a summer abroad was delighted that the dollar had strengthened against the
studying art in Italy. She can join a program with her euro, making purchases in euros relatively less expensive and
university that will cover airfare, room and board, and credit enabling her to buy more.
for her classes. She’s been told that she will need about Luisa’s friend Paul also planned a study-abroad trip, but
$3,000 extra for optional side trips within Italy and for food his trip was to Japan. When he began planning in November
and entertainment outside of the school. In November 2017, 2017, the exchange rate was $1 = ¥123.48, and his estimated
when Luisa first began planning her trip, the exchange rate $3,000 extra amount needed would have equaled ¥370,440.
was $1 = €1.07. At that rate, her $3,000 would buy €3,210. Unfortunately for Paul, the dollar weakened against the yen. By
In mid-June 2018, Luisa left for Italy. The exchange rate mid-June 2018, the exchange rate was $1 = ¥106.07 and his
was $1 = €1.27 and her $3,000 could buy €3,810. Luisa $3,000 for incidentals only equaled ¥318,210.

When one country’s currency strengthens relative to another country’s currency, currency
appreciation occurs, and one unit of the first country’s currency can buy more units of the sec-
ond country’s currency. Conversely, currency depreciation means that one country’s currency
has become relatively weaker and buys fewer units of another currency. For example, in the sum-
mer of 2015, a weak euro made summer travel to many European countries a relative bargain. CONCEPT CLIP

Conversely, exports from U.S. firms have decreased due to the weak global economy and a strong
dollar that makes American goods more expensive.19
Let’s examine the impact of changes in exchange rates on the sale of goods from a local com-
pany to a customer in another country. Example 13.7 shows the effect of currency rate changes
on the transaction.

EXAMPLE 13.7
SuperTubs, Inc., based in Oklahoma, sells its line of whirlpool tubs at home and to foreign
distributors. On January 15, Bonbain, a French distributor of luxury plumbing fixtures, or- How to Calculate the
ders 100 tubs at a price of $1,000 per tub, to be delivered immediately, and to be paid in euros
Value of an Exchange
on March 15. On January 15, the rate of exchange is $1 = €0.80.
in Another Currency
Required:
1. Using the January 15 rate of exchange, how many euros will Bonbain pay SuperTubs
upon completion of the order? What is the value in dollars?
2. Suppose that on March 15 the rate of exchange was $1 = €0.90. What is the value in
dollars of Bonbain’s payment in euros?
3. What is the exchange gain (loss) on the order?
4. Now suppose that on March 15, the rate of exchange was $1 = €0.70. What is the value
in dollars of Bonbain’s payment in euros? What is the exchange gain (loss) on the order?
Solution:
1. Euros to be paid by Bonbain = $100,000 × 0.80 = €80,000
2. Value of Bonbain’s payment = €80,000/0.90 = $88,889 (rounded)
3. SuperTubs has realized an exchange loss = $100,000 – $88,889 = $11,111
4. Value of Bonbain’s payment = €80,000/0.70 = $114,286 (rounded)
SuperTubs has realized an exchange gain = $114,286 – $100,000 = $14,286

19 Heather Long, “Europe Is on Sale for American Travelers,” CNN Money ( January 27, 2015). Taken from [Link]
[Link]/2015/01/27/investing/europe-cheap-travel-euro-11-year-low/. Jeffry Bartash, “U.S. Exports Fall in 2015 for
First Time Since Recession,” Market Watch (February 5, 2016). Taken from [Link]
us-exports-fall-in-2015-for-first-time-since-recession-2016-02-05.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
742 Chapter 13 Emerging Topics in Managerial Accounting

An exchange gain is the gain on the exchange of one currency for another due to appre-
ciation of the home currency. An exchange loss is a loss on the exchange of one currency for
another due to depreciation of the home currency.
Transaction risk also affects the purchase of commodities from foreign companies. Suppose
that on February 20, AmeriMon, Inc. (based in Big Timber, Montana) purchases computers
from NEC (located in Japan) for $50,000, payable in yen on May 20. Assume the spot rate
for yen is 130 per dollar on February 20. It is easy to see that AmeriMon’s true payable is for
6,500,000 yen ($50,000 × 130). If the spot rate for yen is 135 on May 20, it will cost AmeriMon
only $48,148 (6,500,000/135) to get enough yen to pay NEC:

Liability in dollars on February 20 $50,000

Liability in dollars on May 20 48,148
Exchange gain $ 1,852

As we can see, the more favorable May 20 spot rate has resulted in an exchange gain.
Clearly, transaction risk caused by the movement of foreign currency against the dollar
must be taken into account by managers, as it affects the prices paid and received for goods.
If the company does not want to be involved in gambling on exchange rates, the manage-
ment accountant can either encourage the company to make all imports/exports in dollars
or can engage in hedging (a form of insurance against transaction risk). Typically, a forward
exchange contract is used as a hedge. The forward contract requires the buyer to exchange
a specified amount of a currency at a specified rate (the forward rate) on a specified future
date. For example, suppose AmeriMon is concerned that the rate of yen for dollars will
decrease, from 130 yen per dollar on January 15 to potentially 120 yen per dollar on May
20. If the forward rate is ¥128 = $1, the company can purchase a contract to lock in that
rate. The 2-yen difference between the spot rate of 130 and the forward rate of 128 is the
premium that AmeriMon pays the exchange dealer on the transaction. Think of it as an
insurance premium.

Managing Economic Risk Dealing in different currencies can introduce an econom-

ic dimension into currency exchange transactions. Recall that economic risk was defined
as the impact of exchange rate fluctuations on the present value of a firm’s future cash
flows. The risk can affect the relative competitiveness of the firm, even if it never partici-
pates directly in international trade. Take a simple example based on the market for heavy
equipment.
Suppose that U.S. consumers can choose to purchase heavy equipment from either
Caterpillar (based in the United States) or from Komatsu (based in Japan). Assume the price
of one type of equipment is $80,000 from both makers. However, while Caterpillar truly means
$80,000, Komatsu really is interested in ¥10,400,000, its own currency. At an exchange rate
of $1 = ¥130, the price of $80,000 is set. Now suppose that the value of the dollar strength-
ens against the yen and the exchange rate becomes $1 = ¥140. To get the same ¥10,400,000,
Komatsu requires a price of only $74,286. The cost structures of the two firms have not changed
nor has customer demand, but because of currency fluctuations, the Japanese firm has become
more “competitive.” Of course, as the dollar weakens, the position is reversed, and U.S. exports
become relatively cheaper to foreign customers.
How does the accountant manage the company’s exposure to economic risk? Most impor-
tantly, he or she must be aware of it by understanding the position of the firm in the global econ-
omy. As we can see in the Caterpillar–Komatsu example, the two firms were competitors and
were linked through their customers’ participation in the global marketplace. The accountant
provides financial structure and communication for the firm. In preparing the master budget,
for example, budgeted sales must take into account potential strengthening or weakening of the

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 Chapter 13 Emerging Topics in Managerial Accounting 743

currencies of competitors’ countries. Often, the controller’s office is responsible for forecasting
foreign exchange movements.

Transfer Pricing and the Multinational Firm

For the multinational firm, transfer pricing must accomplish two objectives: performance eval-
uation and optimal determination of income taxes.

Performance Evaluation Divisions are frequently evaluated on the basis of income

and return on investment. As is the case for any transfer price, the selling division wants a
high transfer price that will raise its income, and the buying division wants a low transfer
price that will raise its income. But transfer prices in multinational companies are frequently
set by the parent company, making the use of ROI and income suspect. Because they are
not under the control of divisional managers, they may no longer serve as good indicators
of management performance.

Income Taxes and Transfer Pricing If all countries had the same tax structure, then
transfer prices would be set independently of taxes. However, this does not happen. Instead,
there are high-tax countries (like the United States) and low-tax countries (such as the Cayman
Islands). As a result, multinational companies may use transfer pricing to shift costs to high-tax
countries and shift revenues to low-tax countries.
Exhibit 13.22 illustrates this concept as two transfer prices are set. The first transfer
price is $100 as title for the goods passes from the Belgian subsidiary to the reinvoicing
center in Puerto Rico. Because the first transfer price is equal to full cost, profit is zero,
and taxes on zero profit also equal zero. The second transfer price is set at $200 by the
reinvoicing center in Puerto Rico. The transfer from Puerto Rico to the United States
does result in profit, but this profit does not result in any tax because Puerto Rico has no
corporate income taxes. Finally, the U.S. subsidiary sells the product to an external party
at the $200 transfer price. Again, price equals cost, so there is no profit on which to pay
income taxes.

Exhibit 13.22
Action Tax Impact
Use of Transfer Pricing to Affect
Belgian subsidiary of parent company 42% tax rate Taxes Paid
produces a component at a cost of $100 $100 revenue − $100 cost = $0
per unit. Title to the component is Taxes paid = $0
transferred to a reinvoicing center* in
Puerto Rico at a transfer price of $100 per unit.

Reinvoicing center in Puerto Rico, also 0% tax rate

a subsidiary of parent company, $200 revenue − $100 cost = $100
transfers title of component to U.S. Taxes paid = $0
subsidiary of parent company at a
transfer price of $200 per unit.

U.S. subsidiary sells component to 35% tax rate

external company at $200 each. $200 revenue − $200 cost = $0
Taxes paid = $0
*A reinvoicing center takes title to the goods but does not physically receive them. The primary objective of a
reinvoicing center is to shift profits to divisions in low-tax countries.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
744 Chapter 13 Emerging Topics in Managerial Accounting

Consider what would have happened without the reinvoicing center. The goods would
have gone directly from Belgium to the United States. If the transfer price was set at $200,
the profit in Belgium would have been $100, subject to the 42% tax rate. Alternatively, if
the transfer price set was $100, no Belgian tax would have been paid, but the U.S. subsidiary
would have realized a profit of $100 and that would have been subject to the U.S. corporate
income tax rate of 35%.
U.S.-based multinationals are subject to Internal Revenue Code Section 482 on the
pricing of intercompany transactions. This section gives the IRS the authority to reallocate
income and deductions among divisions if it believes that such reallocation will reduce po-
tential tax evasion. Basically, Section 482 requires that sales be made at “arm’s length.” That is,
the transfer price set should match the price that would be set if the transfer were being made
by unrelated parties, adjusted for differences that have a measurable effect on the price. There
are four potential transfer prices sanctioned by the IRS. Their discussion is reserved to more
advanced courses.
Managers may legally avoid taxes. They may not evade them. The distinction is import-
ant. Unfortunately, the difference between avoidance and evasion is less a line than a blurry
gray area. While the situation depicted in Exhibit 13.22 is clearly abusive, other tax-motivated
actions are not. For example, a multinational company may legally decide to establish a needed
research and development center within an existing subsidiary in a high-tax country, since the
costs are deductible. Multinational companies may also use tax-planning information systems
that attempt to accomplish global tax minimization. This is not an easy task.

Ethics Ethical Decisions

Business ethics pose difficulties in a single-country context, but they pose far more prob-
lems in a global context. Given these difficulties, how does the modern corporation con-
duct business in an ethical manner? Is each country different? Is there a baseline? Some
research indicates that human societies do share an ethical basis. However, there are some
prerequisites for the establishment of an ethical business environment. These include basic
societal stability, legitimacy and accountability of government, legitimacy of private own-
ership and personal wealth, confidence in one’s own and society’s future, confidence in the
ability to provide for one’s family, and knowledge of how the system works and how to
participate. ●

A strong underlying system is important for enforcing contracts and provides the basis
for confidence in ethical dealings. For some countries (e.g., the United States and Western
European countries), that system is legal, with deviations punishable by law. For others (e.g.,
Japan and countries in the Middle East), it is cultural, and deviations are punished at least as
severely by loss of honor.
Other ethical problems with differing business laws exist. U.S. companies that contract
with overseas firms may find themselves the target of unfavorable publicity on use of child labor.
During the 1990s, Nike was criticized for low wages (as little as $0.14 per hour in Indonesia),
unsafe working conditions, and the use of child labor. Protests outside Niketown stores and
rampant bad publicity led Nike CEO Phil Knight to announce a turnaround. Nike would raise
wages, enforce U.S. clean air standards in the workplace, and raise the minimum age of workers.
Nike audits its overseas factories and publishes its standards and audit data in annual reports.
The company also banded together with other apparel and sporting goods companies to address
poor conditions in overseas factories.20

20 Max Nisen, “How Nike Solved Its Sweatshop Problem,” Business Insider (May 9, 2013). Taken from [Link]
[Link]/how-nike-solved-its-sweatshop-problem-2013-5.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
 Chapter 13 Emerging Topics in Managerial Accounting 745

Check Point
1. A company builds a manufacturing plant in a foreign trade zone. Materials
costing $1 million each month are imported. The duty is 8%. About 10% of
the materials are defective and disposed of as waste. What is the savings to the
company of locating inside a foreign trade zone?
Answer:
Each month, the company pays a duty of $72,000 ($1,000,000 × 0.9 × 0.08), since only
90% of the material is good and can be sold. If the company were located outside the
foreign trade zone, a duty of $80,000 ($1,000,000 × 0.08) would be paid. The savings is
$8,000 per month.
2. Casey Company purchases pottery from Mexico for resale in its southwestern
gift shops. Purchases must be made in pesos. On May 1, Casey purchased goods
costing 50,000 pesos and agreed to pay, in pesos, on June 1. The spot rates of
dollars for pesos are as follows:
May 1 $1 = 18.25
June 1 $1 = 18.84
How many pesos does Casey expect to pay on June 1? What is the dollar value of the
cost on May 1? On June 1? Did Casey have an exchange gain or an exchange loss?
Now suppose the exchange rate of dollars for pesos on June 1 is $1 to 18
pesos. How many dollars must Casey pay to cover the 50,000 peso cost of the
merchandise? Did Casey have an exchange gain or an exchange loss?
Answer:
Casey has agreed to pay 50,000 pesos on June 1. On May 1, Casey thinks that will cost
$2,739.73 (50,000 pesos/18.25). On June 1, Casey must actually pay $2,653.93 (50,000
pesos/18.84) to get 50,000 pesos. There has been an exchange gain on the transaction.

Now with a June 1 spot rate of $1 = 18 pesos, Casey must still make a 50,000 pesos
payment on June 1; however, it will cost $2,777.78 (50,000 pesos/18) to buy that
amount of pesos. There is an exchange loss on the transaction.

THE ROLE OF COST AND MANAGERIAL OB J ECT I VE ◀ 6

Explain the role of the management
ACCOUNTING IN FRAUD AND FORENSIC accountant in fraud and forensic
ACCOUNTING accounting.

Fraud and forensic accounting are new, growing areas of importance for the management
accountant. The management accountant is involved in fraud prevention and detection. The
management accountant is also involved with forensic accounting, which is the application
of accounting knowledge in legal or other cases to help resolve different types of disputes.
Here’s Why It’s important
Successful fraud and forensic accountants have strong technical expertise in all areas of account-
ing, good investigative skills, and excellent communications skills.

Fraud and Management Accounting

Fraud is defined as wrongful or criminal deception intended to result in financial or person-
al gain. Fraud committed by employees is occupational fraud and is often tied to the fraud

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
746 Chapter 13 Emerging Topics in Managerial Accounting

triangle. According to the Association of Certified Fraud Examiners (ACFE), the fraud
triangle is a model that explains the factors causing someone to commit fraud. The three
components are:
• Perceived unshareable financial need
• Perceived opportunity
• Ability to rationalize the commission of fraud
Basically, it is more likely that a person will engage in fraud if they feel financial need, think
they can successfully get away with fraud, and can lead themselves to believe the fraud
is acceptable—even if only to themselves. Note that all three components must occur to
encourage the individual to commit fraud. The fraud triangle helps explain how previously
stellar employees can be led to commit fraud.
The fraud triangle also suggests the importance of stopping fraud. Most companies work
hard to minimize opportunity and have policies that make it hard to commit successful fraud.
For example, some companies require all employees to take at least some vacation each year.
Many types of fraud would be discovered if the employee was not on site to continue the
cover-up. Mandatory vacation means that another employee will fill in—possibly discovering
anomalies. (Note that in the following Here’s How It’s Used box, Rita Crundwell’s fraud was
discovered while she was on vacation and another employee took over her duties during the
interim.) Companies may require two signatures on any check or payment over a particular
amount. Companies also try to understand human weaknesses and vulnerabilities. Human
resources may make it a policy to check for sudden changes in an employee’s situation, such
as a sudden illness in the family. The HR department can help employees find sources of
additional funds or outside help during the problem times. Fraud hotlines help employees
report anything that seems strange, and then management and management accountants can
follow up.
Fraud is discovered in a number of ways.
• Tips: about 45%
• Accident: about 15%
• Internal audit: about 15%
• Internal controls: about 15%
• External audit: about 10%

Here’s How It’s Used: EMBEZZLEMENT IN A SMALL TOWN

A notorious case in Dixon, Illinois, involved the town’s How did that amount of embezzlement go unnoticed for
comptroller and treasurer, Rita Crundwell. Over a period of so long? Crundwell was well thought of as an employee
22 years, she embezzled over $53 million from the town coffers. and did a good job covering her tracks. She also had ready
Her scheme was simple and highly successful. She opened a answers for questions on the bare-bones budget required of
secret bank account called the RSCDA (Reserve Sewer Capital city departments and draconian cuts in services. The fraud
Development Account) which she made to appear to be a city eventually came to light while Crundwell was on an extended
account—with herself as the only signatory. City funds were vacation. Another employee, acting in her stead, discovered
deposited into another city account (the Capital Development the secret account and the numerous checks written on
Fund) and then false invoices were used to support checks it. She went to higher-ups and alerted the FBI. A 6-month
written on that account to “Treasurer” and then deposited in investigation—kept secret from Crundwell—discovered the
the RSCDA. Crundwell then used the money to support her extensive fraud. Crundwell was indicted and admitted to wire
American quarter horse breeding operation as well as a lavish fraud and money laundering. She is currently serving time in a
lifestyle. federal correctional facility, and is scheduled for release in 2030.

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 Chapter 13 Emerging Topics in Managerial Accounting 747

Note that over half the cases of fraud are discovered through tips and by accident.
Something is strange and an individual asks management about it. In one instance, an employee
of a local chamber of commerce got a manicure at a local salon. The manicurist mentioned that
the chamber was a great employer—why just recently, another employee (let’s call her Cindy)
paid for her manicure with a check drawn on the chamber—given to her, she said, as a birthday
present. The problem is that the first employee did not get that birthday present. She checked
with the chamber CEO who asked for an audit of the financial records to see what was going on.
A $20,000+ fraud was discovered, documented, and reported to authorities. This is an example
of the investigative abilities of the management accountant. Here, the accountant sat down with
the books and combed through them for anything unusual. One thing that jumped out was the
number of checks written to the U.S. Post Office. The accountant asked the CEO: Do you
send out that many packages or mailings? The answer was “No.” Further investigation revealed
that the checks had been written by Cindy to herself and when the bank statements came in,
Cindy—responsible for reconciliation—altered the payee after the fact and recorded the “new”
check. Additionally, Cindy used the chamber credit card for personal purposes. While some
purchase were legitimate, such as paper products and plastic cups for chamber receptions, others
were not. Notably, the card was used to buy dog food and the chamber had no pets.
Prevention is as important as detection. The most important thing for companies or
nonprofit entities to do is to stay aware of financial matters. A small veterinary practice in the
Midwest found that its office manager had embezzled over $100,000 during a 2-year period.
If the veterinarians/owners had been more aware of their financial situation and understood
their costs and revenues, they would have noticed the shortfall much sooner and stopped the
losses. It should have been a simple matter to do a quick calculation of the revenue earned each
week by multiplying the average amount charged by the number of patients seen. While the
office manager was caught and sent to jail, that did not get the practice’s money back—it had
been spent.

Ethical Decisions
Clearly, this section on fraud demonstrates ethical lapses. The bottom line is that fraud requires
Ethics
lying and deception. The fraud, by nature, is not supposed to happen. So the fraudster must
lie continually to make it work. Those with access to funds must be aware of the opportunity
and ability to rationalize. Many employees do not believe they are getting paid what they are
worth. It’s a short leap to believing they have the right to make up for it by taking something
when possible. The way to nip this in the bud is to recognize one’s own ability and potential
desire to rationalize and stop it. One good way might be to envision Rita Crundwell, in prison
until 2030. ●

The ACFE is the largest provider of antifraud training and education. The association
sponsors the Certified Fraud Examiner (CFE) credential. CFEs have undertaken academic
and professional requirements and have passed the Certified Fraud Examiner exam. This exam
tests the applicant’s knowledge of the four main areas of fraud examination: fraud prevention
and deterrence, financial transactions and fraud schemes, investigation, and the law. Its website
([Link]) gives details on membership and CFE requirements.

Forensic Accounting in Management Accounting

Nearly all cases in fraud and forensic accounting involve the identification and quantification of
financial damages resulting from the issues raised in the case. The plaintiff in a case attempts to
prove that some amount of financial damages did occur, while the defendant attempts to prove
that either no or minimal damages occurred. Each party in the case uses cost/managerial con-
cepts to support and defend their damage estimates. The major areas of forensic practice involve
fraud, litigation support, and business valuations.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
748 Chapter 13 Emerging Topics in Managerial Accounting

Important managerial accounting concepts include incremental/differential costs, relevant

costs, activity-based costing, cost behavior, cost-volume-profit analysis, and the matching prin-
ciple. Just as important as understanding and applying these concepts is the ability to explain
them clearly and persuasively to opponents, judges, and a jury. This requires that the forensic
accounting expert be very knowledgeable and skilled in defending these concepts. Exhibit 13.23
shows the use of various cost and management accounting concepts in forensic accounting.

Exhibit 13.23
• Cost behavior is used in almost all damage calculations to determine the amount of
Applying Different Types of financial harm that resulted from the liability found by the court. Cost behavior is also an
Accounting Knowledge to Forensic important determinant of whether predatory pricing has occurred in an antitrust case.
Accounting • Differential/incremental costs are used in the calculation of damages in answering questions
about the type and amount of costs to include in the damage calculation. Frequently, the
issue in a breach of contract case is the determination of which costs are different as a
result of the contract breach. The concept of relevant costs is useful in determining which
costs relate to the issues being litigated. For example, lost wages are relevant in measuring
damages in a wrongful discharge case, but value of lost household services would not be
relevant in calculating damages.
• The matching concept is useful in determining which costs logically should be matched with
contract revenue in a breach of contract case.
• Consistency is a useful concept in evaluating whether a company has changed accounting
policy or practices in measuring costs that should be charged under a contract. For
example, in a cost-based government contract, a frequent question that arises pertains
to the appropriateness of a company using accelerated depreciation to charge the
government for its share of facility deprecation costs when the company uses straight-line
depreciation for all other purposes.
Source: Taken from Lester E. Heitger and Dan L. Heitger, “Incorporating Forensic Accounting and
Litigation Advisory Services into the Classroom,” Issues in Accounting Education (November 2008):
561–572. Used with permission.

The nature of forensic accounting activities is both interesting and challenging. For exam-
ple, some common characteristics of forensic accounting practice include detective work and
problem solving, its adversarial nature, a range of answers rather than one correct answer, and
the importance of excellent communications skills.
Detective work and problem solving: Because there is conflict in most cases, some data
and information are not clear or readily available. The accountant must use his/her knowledge
and skills to find, assemble, and present the relevant information in the best and most under-
standable way possible.
Adversarial nature: Because virtually all court cases involve conflict of some sort, the ac-
counting expert must learn to work, analyze, and present information for the court in an ad-
versarial environment. Because there are differences of opinion about case issues, accounting
issues, and measurements in the case, forensic accountants must be effective in an adversarial
environment.
Range of potential answers: Often, there is not a correct answer, but only better or more
persuasive answers. Many cases have legitimate differences of opinion. A forensic accountant
must decide what is the better, more logical, and more persuasive solution to the dispute, given
the information and issues. The accountant uses his/her best judgment to determine the best
answer to the issues in the case.
Excellent communication skills: Strong communications skills, both written and oral,
are essential. Accountants often need to explain the financial information to laypeople because
judges and juries typically know very little about accounting concepts. In addition, the adver-
sarial nature of the work means that the opposing side will be doing its best to argue against the

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 Chapter 13 Emerging Topics in Managerial Accounting 749

tack taken by the forensic accountant. Thus, the forensic accountant must both explain concepts
and rebut the opposing views. Written communications skills are essential, as the accountant
must write reports that explain accounting concepts as well as the value determined.
It is difficult to overstate the value of the role of managerial/cost accounting in litigating
and resolving cases. Whether criminal fraud, litigation, valuations, or any other type of dispute,
the crucial issues of how much the damages are typically can only be resolved by accurate and
defendable cost/managerial measurements. Even the liability side of a trial may be impacted by
the knowledge and testimony of forensic accounting cost experts. For example, determining
whether or not “predatory pricing” took place in an antitrust case is determined by whether
or not a company priced products or services below their average variable costs. In summary,
managerial/cost accountants play a crucial role in the world of forensic accounting.

Check Point
1. What are the three legs of the fraud triangle?
Answer:
They are financial need, opportunity, and ability to rationalize.
2. Jim Alberts is majoring in accounting at the local college. Jim is highly
intelligent and very knowledgeable about all areas of accounting. He would like
to go into forensic accounting. Jim is not a skilled writer or speaker, but he feels
that is no problem, since most accountants work in solitude anyway. Is he right?
What advice would you give him in order to maximize his chances of working in
forensic accounting?
Answer:
Communications skills are vital to the forensic accountant. Jim will need to be able to
explain accounting concepts clearly and succinctly to judges and juries. He will need
both written and oral communications skills.

SUMMARY OF LEARNING OBJECTIVES

LO1. Explain enterprise risk management and its importance for achieving strategy.
• The most important reason for using enterprise risk management is to help the orga-
nization achieve its strategy through identifying, measuring, and managing its most
important risks and opportunities.
• Determining an organization’s desired level of risk taking, or risk appetite, is nec-
essary to ensure that its portfolio of risks and opportunities aligns with the returns
expected from shareholders and other key stakeholders.
• After determining risk appetite, enterprise risk management involves identifying the
top risks, assessing risks at the inherent level, and managing (or responding to) risks
such that the remaining residual risks align with the organization’s risk appetite.
• Risk monitoring is the final step in the iterative enterprise risk management process,
whereby management continually searches for emerging risks, reevaluates the accura-
cy of its risk assessments, and considers more effective risk response alternatives.
LO2. Understand the role of managerial accounting in business sustainability.
• Business sustainability focuses on creating long-term organizational value through in-
ternally understanding, measuring, and managing the key threats and opportunities
to achieving the organization’s strategy and then externally reporting to key stake-
holders on the successes and failures of such efforts.

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750 Chapter 13 Emerging Topics in Managerial Accounting

• The important aspects of business sustainability can be characterized in the busi-

ness sustainability cycle, which includes strategy, stakeholder engagement, risk
management, performance measurement, stakeholder reporting, and sustainability
assurance.
• Managerial accounting plays an increasingly important role in the business
sustainability cycle, including areas such as in quantifying the results of stake-
holder engagement activities, providing critical inputs to the enterprise risk
management process, creating nonfinancial and financial performance measures
relevant to the organization’s top risks and opportunities, and communicating
the organization’s overall business sustainability “story”, both qualitatively and
quantitatively.
LO3. Define quality costs and describe the approaches used for reporting and controlling
quality costs.
• Quality costs are the costs of preventing or detecting poor quality.
• There are four categories of quality costs: prevention, appraisal, internal failure, and
external failure.
• A quality cost report is prepared by listing costs for each item within each of the four
major quality cost categories.
• Knowing total quality costs allows managers to assess their financial importance.
• Knowing the distribution of quality costs by category allows managers to assess the
relative importance of each category.
• An interim quality cost report compares actual quality costs with budgeted quality
costs and allows managers to assess the effectiveness of its quality improvement efforts
for the period.
• A multiple-period trend report provides a trend graph for several years and allows
managers to assess the direction and change of quality costs since the inception of its
quality improvement program.
LO4. Describe the basics of lean manufacturing and lean accounting.
• Lean manufacturing is characterized by lean thinking—focusing on customer value,
value streams, production flow, demand-pull, and perfection.
• Value streams are made up of all activities, both value-added and nonvalue-added,
required to bring a product group or service from its starting point (e.g., customer
order or concept for a new product) to a finished product in the hands of the
customer.
• Value-stream analysis allows waste to be identified and eliminated.
• Lean accounting is an approach designed to support and encourage lean manufacturing.
• Average costing and the expanded use of nonfinancial measures for operational con-
trol are typical lean accounting approaches.
• The average product cost is the total value-stream cost of the period divided by the
units shipped in the period.
• Lean control uses a mix of operational, capacity, and financial metrics to monitor and
improve performance.
LO5. Explain the role of the management accountant in the international environment.
• The management accountant provides financial and business expertise and must stay
up to date on the ever-changing international business environment.
• Companies involved in international business may engage in import and export activ-
ities, purchase wholly owned subsidiaries, or participate in joint ventures.
• Three types of foreign currency risk are transaction risk, economic risk, and transla-
tion risk.
• Multinational companies with subsidiaries in both high- and low-tax countries may
use transfer pricing to shift costs to the high-tax countries (where their deductibility
will lower tax payments) and to shift revenues to low-tax countries.

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 Chapter 13 Emerging Topics in Managerial Accounting 751

LO6. Explain the role of the management accountant in fraud and forensic accounting.
• Fraud is wrongful or criminal deception intended to result in financial or personal gain.
• The triangle is a model that explains what makes someone commit fraud. Its compo-
nents are:
■ Perceived unshareable financial need
■ Perceived opportunity
■ Ability to rationalize the commission of fraud
• Forensic accounting is the application of accounting knowledge in legal or other cases
to help resolve different types of disputes.
■ Fraud
■ Litigation support
■ Business valuation
• Many cost concepts are critical in determining valuation.

SUMMARY OF IMPORTANT EQUATIONS

1. Risk Response Benefit = Inherent Risk – Residual Risk
2. Risk Response Net Benefit = Response Benefit – Response Cost
3. Value-Stream Product Cost = Total Actual Value-Stream Costs/Units Shipped
4. Value-Stream Product Cost = Unit Materials Cost + Average Conversion Cost
5. Unit Materials Cost (for each product) = Actual Materials Cost/Units Shipped
6. Average Conversion Cost = Total Actual Conversion Costs/Units Shipped
7. Conversion Cost Rate = Total Actual Conversion Costs/Total Net Production Hours
8. Conversion Cost per Unit = Conversion Cost Rate × Cycle Time

EXAMPLE 13.1 How to use net benefit to evaluate risk response alternatives, page 707
EXAMPLE 13.2 How to prepare a quality cost report, page 721
EXAMPLE 13.3 How to prepare an interim quality performance report, page 724
EXAMPLE 13.4 How to prepare multiple-period quality trend reports, page 726
EXAMPLE 13.5 How to calculate production time for traditional and cellular manufacturing, page 730
EXAMPLE 13.6 How to calculate value-stream product costs, page 735
EXAMPLE 13.7 How to calculate the value of an exchange in another currency, page 741

KEY TERMS
Appraisal costs, 720, cost incurred to determine whether products and services are conforming
to requirements.
Business sustainability, 709, the practice of creating long-term organizational value through
internally understanding, measuring, and managing the key threats and opportunities to achiev-
ing the organization’s strategy and then externally reporting to key stakeholders on the successes
and failures of such efforts.
Certified Fraud Examiner (CFE), 747, a premier credential for the forensic accountant,
administered by the Association of Certified Fraud Examiners.
Control costs, 720, the costs of preventing or detecting poor quality.

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752 Chapter 13 Emerging Topics in Managerial Accounting

Corporate sustainability reporting (CSR), 715, the voluntary public disclosure of qualitative
and/or quantitative information about an organization’s performance on one or more financial
and/or nonfinancial dimensions.
Costs of quality, 720, costs that exist because poor quality may or does exist.
Currency appreciation, 741, when one country’s currency strengthens relative to another
country’s currency.
Currency depreciation, 741, when one country’s currency weakens relative to another coun-
try’s currency.
Cycle time, 734, the length of time required to produce one unit of a product.
Defective product, 719, a product or service that does not conform to specifications.
Duration-based costing (DBC), 734, uses a single rate to assign conversion costs and approx-
imates a comprehensive ABC system based in duration drivers.
Economic risk, 740, the possibility that a firm’s present value of future cash flows will be
affected by exchange rate fluctuations.
Enterprise risk management (ERM), 702, the formal process of aligning an organization’s
overall desired level of risk taking with its strategy and then managing its top risks in a manner
that maintains this alignment.
Exchange gain, 742, the gain on the exchange of one currency for another due to appreciation
of the home currency.
Exchange loss, 742, the loss on the exchange of one currency for another due to depreciation
of the home currency.
Exchange rates, 740, the rate at which one unit of a currency can be traded for another currency.
External failure costs, 720, costs incurred because products fail to conform to requirements
after being sold to outside parties.
Failure costs, 720, the costs incurred by an organization because failure activities are performed.
Foreign trade zones, 738, areas near a customs port of entry that are physically on U.S. soil but
are considered by the U.S. government to be outside U.S. commerce. Goods entering a foreign
trade zone are not subject to duty until they leave the zone.
Forensic accounting, 745, the application of accounting knowledge in legal or other cases to
help resolve different types of disputes.
Forward contract, 742, requires the buyer to exchange a specified amount of a currency at a
specified rate (the forward rate) on a specified future date.
Forward rate, 742, the currency exchange rate specified for a particular future date.
Fraud, 745, wrongful or criminal deception intended to result in financial or personal gain.
Fraud triangle, 746, a model that explains the factors causing someone to commit fraud. The
factors are: opportunity, perceived need, and ability to rationalize the fraudulent actions.
Greenwashing, 719, a situation in which stakeholders believe that an organization’s corporate
sustainability report contains environmental information that is materially biased in favor of the
reporting organization.
Inherent risk, 703, the risk that exists absent of any risk management action to reduce or avoid
the risk.
Integrated reporting, 719, the combination of an organization’s annual report (i.e., 10-K)
with its sustainability report to form one combined (or integrated) report for all stakeholders,
including investors.
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 Chapter 13 Emerging Topics in Managerial Accounting 753

Interim quality performance report, 724, a comparison of current actual quality costs with
short-term budgeted quality costs.
Interim quality standards, 724, a standard based on short-run quality goals.
Internal failure costs, 720, costs incurred because products and services fail to conform to
requirements where lack of conformity is discovered prior to external sale.
JIT purchasing, 731, a system that requires suppliers to deliver parts and materials just in time
to be used in production.
Joint venture, 740, a type of partnership in which investors co-own the enterprise.
Lean manufacturing, 727, an approach designed to eliminate waste and maximize customer
value.
Manufacturing cells, 729, a plant layout where all the operations (machines) that are needed
to produce a family of products are grouped in close proximity, typically in a semicircle.
Maquiladora, 740, a manufacturing plant, located in Mexico, that processes imported materi-
als and re-exports them to the United States.
Multinational corporation (MNC), 738, a company with divisions in more than one country.
Multiple-period quality trend report, 725, a graph that plots quality costs (as a percentage of
sales) against time.
Outsourcing, 739, the payment by a company for a business function formerly done in
house.
Portfolio ERM perspective, 705, the practice of managing a company’s most important risks
in a collective (or portfolio) fashion, such that the residual risks that remain align with the
company’s risk appetite.
Prevention costs, 720, costs incurred to prevent or detect poor quality.
Quality of conformance, 719, a product or service that conforms to its design requirements
or specifications.
Quality product or service, 719, a product or service that meets or exceeds customer
expectations.
Residual risk, 705, the risk that remains after any risk management action has been taken.
Risk appetite, 703, an organization’s overall desired level of risk taking.
Risk response benefit, 705, the difference between the inherent risk and the residual risk
produced by the particular risk response.
Risk response cost, 706, the incremental cost incurred by the company to implement the given
risk response.
Risk response net benefit, 706, the benefit of the risk response minus the cost of risk response.
Spot rate, 740, the exchange rate of one currency for another for immediate delivery.
Stakeholder engagement, 712, the process by which an organization’s management interacts
with its key stakeholders.
Stakeholders, 710, those individuals or groups that (1) are affected by an organization’s pursuit
of its strategy or (2) can affect an organization’s ability to achieve its strategy.
Sustainability assurance, 717, the external verification that an independent party provides
concerning the content of a corporate sustainability report and/or the process used in preparing
a corporate sustainability report.

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754 Chapter 13 Emerging Topics in Managerial Accounting

Tariff (duty), 738, a tax on imports levied by the federal government.

Transaction risk, 740, the possibility that future cash transactions will be affected by changing
exchange rates.
Translation (or accounting) risk, 740, the degree to which a firm’s financial statements are
exposed to exchange rate fluctuation.
Value stream, 728, all processes that a product must pass through, from the initial customer
order to the delivery to the customer.
Zero defects, 719, means that all products conform to specifications.

REVIEW PROBLEMS
I. Quality Cost Classification, Quality Improvement, and Profitability
At the beginning of 20X2, Landing Company initiated a quality improvement program.
Because of the quality improvement efforts, the number of defective units decreased compared
to the previous year. By the end of 20X2, scrap and rework had both decreased. The president of
the company was pleased to hear of the success but wanted some assessment of the financial im-
pact of the improvements. To make this assessment, the following financial data were collected
for the current year (20X2) and the preceding year, 20X1:

20X1 20X2
Sales $15,000,000 $15,000,000
Scrap 600,000 450,000
Rework 900,000 600,000
Product inspection 150,000 200,000
Vendor certification 60,000 150,000
Product warranty 1,200,000 900,000
Process acceptance 90,000 100,000

Required:
1. Classify the costs as prevention, appraisal, internal failure, or external failure.
2. Compute quality cost as a percentage of sales for each of the two years. By how much
has profit increased because of quality improvements? Assuming that quality costs
can be reduced to 3% of sales, how much additional profit is available through quality
improvements (assuming that sales revenues will remain the same)?

Solution:
1. Prevention costs: Vendor certification;
Appraisal costs: Product inspection and process acceptance
Internal failure costs: Scrap and rework
External failure costs: Product warranty
2. Year 20X1: total quality costs: $3,000,000; percentage of sales: 20%
($3,000,000/$15,000,000). Year 20X2: total quality costs: $2,400,000; percentage of
sales: 16% ($2,400,000/$15,000,000). Profit has increased by $600,000 [(0.20 – 0.16)
× $15,000,000)]. If quality costs drop to 3% of sales, another $1,950,000 of profit
improvement is possible ($2,400,000 – $450,000).

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 Chapter 13 Emerging Topics in Managerial Accounting 755

II. Foreign Trade Zones; Foreign Currency Exchange

Golo, Inc., has two manufacturing plants, one in Singapore and the other in San Antonio. The
San Antonio plant is located in a foreign trade zone. On March 1, Golo received a large order
from a Japanese customer. The order is for 10,000,000 yen to be paid on receipt of the goods,
scheduled for June 1. Golo assigned this order to the San Antonio plant; however, one necessary
component for the order is to be manufactured by the Singapore plant. The component will be
transferred to San Antonio on April 1, using a cost-plus transfer price of $10,000 (U.S. dollars).
Typically, two percent of the Singapore parts are defective. The U.S. tariff on the component
parts is 30%. The carrying cost for Golo is 15% per year.
The following spot rates for $1 U.S. are as follows:

Exchange Rates of $1 for

Yen Singapore Dollars
March 1 107.00 1.60
April 1 107.50 1.55
June 1 107.60 1.50

Required:
1. What is the total cost of the imported parts from Singapore to the San Antonio plant in
U.S. dollars?
2. Suppose that the San Antonio plant were not located in a foreign trade zone; what would
be the total cost of the imported parts from Singapore?
3. How much does Golo expect to receive from the Japanese customer in U.S. dollars, using
the spot rate at the time of the order?
4. How much does Golo expect to receive from the Japanese customer in U.S. dollars, using
the spot rate at the time of payment?

Solution:
1.
Transfer price $10,000
Tariff ($9,800 × 0.3) 2,940
Total cost $12,940

The transfer price was set in U.S. dollars, so there is no currency exchange involved for the
San Antonio plant.
The San Antonio plant is in a foreign trade zone, so the 30% tariff is paid only on the
good parts, costing $9,800 ($10,000 × 0.98).
2. If the San Antonio plant were located outside the foreign trade zone, the cost of the
imported parts would be as follows:

Transfer price $10,000

Tariff ($10,000 × 0.3) 3,000
Carrying cost of tariff* 75
Total cost $13,075
*$3,000 × 2/12 × 0.15 = $75

3. On March 1, Golo expects to receive $93,458 (10,000,000/107.00).

4. On June 1, Golo expects to receive $92,937 (10,000,000/107.60).

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756 Chapter 13 Emerging Topics in Managerial Accounting

DISCUSSION QUESTIONS
1. What is the most important reason for an organization to use enterprise risk
management?
2. What is the difference between inherent risk and residual risk?
3. Why should the incremental cost of a risk response alternative be considered when
deciding how best to respond to an important risk?
4. How is business sustainability different from environmental sustainability?
5. Explain how performance measurement can help improve an organization’s business
sustainability efforts.
6. Identify and discuss the four kinds of quality costs.
7. Discuss the benefits of quality cost reports that simply list the quality costs for each
category.
8. What is a focused value stream?
9. Why are units shipped used to calculate the value-stream cost?
10. When will the average unit cost be used for value streams?
11. How do international issues affect the role of the management accountant?
12. What is a foreign trade zone, and what advantages does it offer U.S. companies?
13. Define outsourcing, and discuss why companies may outsource various functions.
14. Define forensic accounting.
15. Define the fraud triangle.

MULTIPLE-CHOICE QUESTIONS
13-1 A fire insurance policy on a manufacturing plant is an example of a risk reduction
alternative that would reduce which component of the inherent risk of a plant fire?
a. Likelihood only
b. Impact only
c. Both likelihood and impact
d. Neither likelihood nor impact
13-2 An organization’s overall desired level of risk taking is referred to as its
a. riskiness.
b. inherent risk.
c. monitoring ability.
d. risk appetite.
13-3 A common way to assess the likelihood of an inherent risk is to measure its
a. incremental cost.
b. probability.
c. lost revenues.
d. company reputation.
13-4 Which of the following risk response items would not be affected by an increase in
the cost of managing a strategic alliance partnership that was formed to reduce a top
organizational risk?
a. Risk response net benefit
b. Risk response cost
c. Risk response benefit
d. All of these.
e. None of these.

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 Chapter 13 Emerging Topics in Managerial Accounting 757

13-5 Beginning with strategy, which of the following items lists the areas of the business
sustainability cycle in the correct order in which they should be performed? (Note:
Not all areas are contained in each list.)
a. Sustainability assurance, sustainability reporting, risk management, performance
measurement
b. Performance measurement, risk management, sustainability reporting, stakeholder
engagement
c. Stakeholder engagement, risk management, sustainability assurance, performance
measurement
d. Risk management, stakeholder engagement, sustainability reporting, sustainability
assurance
e. Stakeholder engagement, risk management, performance measurement, sustainabili-
ty reporting
13-6 In which areas of an organization’s value chain can important business sustainability
risks or opportunities arise?
I. Research & Development II. Customer Service
III. Manufacturing IV. Warehousing & Distribution
a. I only
b. II only
c. III only
d. II and IV
e. I, II, III, and IV
13-7 Exhibit 13.8 contains results from KPMG’s survey of corporate responsibility
reporting,21 showing how the percentage of the world’s 250 largest companies (i.e., the
larger green bubbles) that issue corporate responsibility reports has changed over the
years. According to Exhibit 13.8, when was the first year in which a majority (i.e., more
than 50%) of these companies issued corporate responsibility reports?
a. 1999
b. 2002
c. 2005
d. 2008
e. 2011
13-8 Which of the following items correctly describes an important difference (in most
countries and business environments) between traditional financial reporting and
corporate sustainability reporting?
a. Corporate sustainability reporting is required, while traditional financial reporting is
not required.
b. Corporate sustainability reporting is voluntary, but the contents of any such report
are required to be verified by an independent third party, whereas traditional finan-
cial reporting is required and its contents must be verified by an independent third
party.
c. No published reporting standards exist for organizations to follow when preparing
and issuing corporate sustainability reports, whereas published reporting standards
do exist for organizations to follow when preparing and issuing traditional financial
reports.
d. None of these.

21 From KPMG’s “Currents of Change: The KPMG Survey of Corporate Responsibility Reporting” (2015). Taken from
[Link]
[Link].

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758 Chapter 13 Emerging Topics in Managerial Accounting

13-9 Which of the following is a prevention cost?

a. Inspection of materials
b. Continuing supplier verification
c. Prototype inspection
d. Recalls
13-10 Which of the following is an external failure cost?
a. Design reviews
b. Warranties
c. Field testing
d. Vendor certification
13-11 Internal failure costs are incurred
a. to prevent poor quality in the products or services being produced.
b. because products or services do not conform to requirements after being delivered to
the customer.
c. to determine whether products and services are conforming to their requirements.
d. because products and services do not conform to specifications or customer
needs prior to the product being shipped or the service being rendered to outside
parties.
13-12 Lean manufacturing seeks to achieve all of the following except for
a. zero defects.
b. maximizing customer value.
c. zero inventories.
d. waiting.
13-13 When materials costs differ significantly among products in a value stream, the value-
stream product cost is calculated by which of the following?
a. Unit Materials Cost + Value-Stream Costs/Units Shipped
b. Unit Materials Cost + Value-Stream Conversion Costs/Units Shipped
c. Value-Stream Costs/Units Produced
d. Value-Stream Costs/Units Shipped
13-14 A manufacturing cell within a value stream has three processes and the following
associated processing times:
Drilling: 12 minutes
Inserting: 6 minutes
Finishing: 2 minutes
How many units can the cell produce per hour (on a continuous running basis)?
a. 10 units per hour
b. 3 units per hour
c. 5 units per hour
d. 30 units per hour
13-15 Which of the following is true regarding foreign trade zones?
a. They are pieces of land physically located in foreign countries that are subject to the
laws of the United States.
b. They must be located near seaports.
c. Goods that enter a foreign trade zone are not subject to tariff until they leave the zone
for destinations in the United States.
d. Goods sold in a foreign trade zone are not subject to U.S. income taxes.
e. All of these.

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 Chapter 13 Emerging Topics in Managerial Accounting 759

13-16 A manufacturing plant located in Mexico that processes imported materials and
reexports them to the United States is called a(n)
a. maquiladora.
b. foreign trade zone.
c. joint venture.
d. exchange venture.
e. foreign transaction.
13-17 The following spot rates for $1 in terms of yen and pounds were in effect for June 1 and
November 1.

June 1 November 1
Japanese yen 115.0 118.0
British pound 0.699 0.650

Did the U.S. dollar appreciate or depreciate against these currencies between June 1 and
November 1?
Japanese Yen British Pound
a. appreciate appreciate
b. appreciate depreciate
c. depreciate depreciate
d. depreciate appreciate
e. Cannot tell from the information given

13-18 The premier credential for the forensic accountant is the

a. CPA.
b. CFE.
c. CMA.
d. CIA.
e. None of these.
13-19 Which of the following is not true of forensic accounting?
a. Many cases are adversarial in nature.
b. Excellent written and oral communications skills are required.
c. The forensic accountant must be able to explain basic accounting concepts to
nonaccountants.
d. The forensic accountant is trained to determine the correct answer for each case.
e. The forensic accountant may earn specialized certification.

BRIEF EXERCISES: SET A

Brief Exercise 13-20 Using Net Benefit to Evaluate Risk Response Alternatives OB J ECT I VE ◀ 1
Cooper Movie Studio Corp. makes movies and is interested in lowering its operating costs Example 13.1
for the following year, while maintaining the high quality and appeal of its movies. Cooper’s
management is concerned about the additional costs the company would have to incur if new
industry regulation is passed by Congress. The chart at the top of the next page contains a
description of this top risk, an inherent risk assessment, three risk response alternatives, and a
residual risk assessment for each response alternative.

(Continued)

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760 Chapter 13 Emerging Topics in Managerial Accounting

Inherent Risk Risk Response Residual Risk

Impact Impact
(on operating (on operating
Risk Likelihood costs) Alternatives Likelihood costs)
Poor behavior by others 30% $80,000,000 A—Share Cooper’s 20% $80,000,000
in the industry results in effective marketing
Congress passing costly processes with competitors
new legislation that to help mitigate poor
regulates the behavior of industry behavior
all movie studios. B—Lobby Congress 15% $50,000,000
on behalf of the movie
industry generally and
Cooper in particular
C—Take no action in 30% $80,000,000
response to possible new
regulation

Finally, Cooper’s management accountants estimate that the incremental cost of implement-
ing risk response A is $3,000,000 and the incremental cost of implementing risk response B is
$13,000,000.

Required:
1. Calculate the inherent risk for Cooper.
2. Calculate the residual risk for Cooper associated with each of the three risk response
alternatives A, B, and C.
3. Calculate the benefit for Cooper associated with each of the three risk response
alternatives A, B, and C.
4. Calculate the net benefit for Cooper associated with each of the three risk response
alternatives A, B, and C.
5. Using net benefit as the criterion, which risk response should Cooper choose to
implement?

O BJE C T I V E 3 ▶
Brief Exercise 13-21 Quality Cost Report
Example 13.2 Whitley Company had total sales of $1,000,000 for the year ending 20X1. The costs of quality
are given below.

Returns/allowances $50,000
Design changes 60,000
Prototype inspection 13,000
Downtime 40,000
Quality circles 2,000
Packaging inspection 14,000
Field testing 6,000
Complaint adjustment 65,000

Required:
1. Prepare a quality cost report, classifying costs by category and expressing each category as
a percentage of sales. What message does the cost report provide?
2. Prepare a bar graph and pie chart that illustrate each category’s contribution to total
quality costs. Comment on the significance of the distribution.

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 Chapter 13 Emerging Topics in Managerial Accounting 761

Brief Exercise 13-22 Interim Quality Performance Report OB J ECT I VE ◀ 3

Andresen Company had the following quality costs for the years ended June 30, 20X1 and Example 13.3
20X2:

20X1 20X2
Prevention costs:
Quality audits $ 30,000 $ 45,000
Vendor certification 60,000 90,000
Appraisal costs:
Product acceptance 45,000 67,500
Process acceptance 37,500 54,750
Internal failure costs:
Retesting 51,000 45,000
Rework 108,000 90,000
External failure costs:
Recalls 75,000 60,000
Warranty 165,000 150,000

At the end of 20X1, management decided to increase its investment in control costs by 50% for
each category’s items, with the expectation that failure costs would decrease by 20% for each
item of the failure categories. Sales were $6,000,000 for both 20X1 and 20X2.

Required:
1. Calculate the budgeted costs for 20X2, and prepare an interim quality performance report.
2. Comment on the significance of the report. How much progress has Andresen made?

Brief Exercise 13-23 Quality Trend Report Objective OB J ECT I VE ◀ 3

Norris Company implemented a quality improvement program and tracked the following for Example 13.4
the 5 years:

Quality Costs Actual Sales Costs as a Percentage of Sales

20X1 $880,000 $4,000,000 22.00%
20X2 840,000 4,200,000 20.00
20X3 765,000 4,500,000 17.00
20X4 700,000 5,000,000 14.00
20X5 594,000 5,400,000 11.00

By cost category as a percentage of sales for the same period of time:

Prevention Appraisal Internal Failure External Failure

20X1 1.50% 2.50% 6.50% 11.50%
20X2 2.75 3.25 4.00 10.00
20X3 3.00 5.00 2.75 6.25
20X4 3.50 3.50 2.00 5.00
20X5 3.75 2.25 1.50 3.50

Required:
1. Prepare a bar graph that reveals the trend in quality cost as a percentage of sales (time on the
horizontal axis and percentages on the vertical). Comment on the message of the graph.

(Continued)

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762 Chapter 13 Emerging Topics in Managerial Accounting

2. Prepare a bar graph for each cost category as a percentage of sales. What does this graph
tell you?

O BJE C T I V E 3 ▶
Brief Exercise 13-24 Continuous Flow vs. Departmental Manufacturing
Example 13.5 Mabbut Company has the following departmental manufacturing layout for one of its plants:

5 minutes 10 minutes
Wait time = 12 minutes Move and wait time = 20 minutes
Cutting Welding

Move and wait time = 25 minutes

8 minutes 7 minutes
Move and wait time = 18 minutes
Polishing Finishing

A consulting firm recommended a value stream with the following manufacturing cell:

10 minutes 5 minutes

Welding Cutting

Polishing Finishing

8 minutes 7 minutes

Required:
1. Calculate the total time it takes to produce a batch of 10 units using the traditional
departmental manufacturing layout.
2. Using cellular manufacturing, how much time is saved producing the same batch of
10 units? Assuming the cell operates continuously, what is the production rate? Which
process controls this production rate?
3. Assume the processing time of Welding is reduced to 6 minutes, while the times of
the other processes stay the same. What is the production rate now, and how long
will it take to produce a batch of 10 units if the cell is in a continuous production
mode?

O BJE C T I V E 3 ▶
Brief Exercise 13-25 Value Stream Product Costing
Example 13.6 During the week of May 10, Hyrum Manufacturing produced and shipped 16,000 units of its
aluminum wheels: 4,000 units of Model A and 12,000 units of Model B. The cycle time for

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 Chapter 13 Emerging Topics in Managerial Accounting 763

Model A is 1.09 hours and for Model B is 0.47 hour. The following costs and production hours
were incurred:

Hyrum Manufacturing
Value-Stream Costs and Production Hours
This Week, May 10
Net Hours Materials Salaries/Wages Machining Other Total Cost
Order processing 1,600 $ 18,000 $ 18,000
Production planning 100 36,000 36,000
Purchasing 800 27,000 27,000
Stamping 2,000 $267,000 145,500 $36,000 $18,000 466,500
Welding 2,400 100,000 42,000 42,000 12,000 196,000
Cladding 500 75,000 50,000 125,000
Inspection 600 10,500 10,500
Packaging and shipping 600 9,000 9,000
Invoicing 1,400 12,000 12,000
Totals 10,000 $442,000 $350,000 $78,000 $30,000 $900,000

Required:
1. Assume that the value-stream costs and total units shipped apply only to one model
(a single-product value stream). Calculate the unit cost, and comment on its accuracy.
2. Assume that Model A is responsible for 40% of the materials cost. Calculate the unit cost
for Models A and B, and comment on its accuracy. Explain the rationale for using units
shipped instead of units produced in the calculation.
3. Calculate the unit cost for the two models, using DBC. Explain when and why this cost is
more accurate than the unit cost calculated in Requirement 2.

Brief Exercise 13-26 Exchange Gains and Losses OB J ECT I VE ◀ 5

On March 1, Friedle Import-Export Company purchased merchandise costing 70,100 Mexican Example 13.7
pesos. Payment was due, in pesos, on June 1. The exchange rates of pesos for $1 were as follows:

March 1 $1 = 10.9 pesos

June 1 $1 = 11.4 pesos

Round all answers to the nearest dollar.

Required:
1. What is the liability in dollars on March 1?
2. What is the liability in dollars on June 1?
3. If Friedle pays on June 1, is there an exchange gain or loss? If so, how much is it?

BRIEF EXERCISES: SET B

Brief Exercise 13-27 Using Net Benefit to Evaluate Risk Response Alternatives OB J ECT I VE ◀ 1
Palakiko’s Fish Taco Hut is a small start-up restaurant in Hanalei. Palakiko recently completed Example 13.1
an online risk management course and has identified food safety as his restaurant’s top risk.
Specifically, he is concerned that the potential of spoiled food resulting from inadequate refrig-
eration and food preparation techniques could drastically increase restaurant costs. The chart

(Continued)

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764 Chapter 13 Emerging Topics in Managerial Accounting

below contains a description of this top risk, an inherent risk assessment, three risk response
alternatives, and a residual risk assessment for each response alternative.

Inherent Risk Risk Response Residual Risk

Impact Impact
(on operating (on operating
Risk Likelihood costs) Alternatives Likelihood costs)
Inadequate refrigeration 40% $1,000,000 A—Invest in new and 15% $325,000
and food preparation larger refrigeration units
techniques result in costly B—Design and implement 35% $300,000
food spoilage problems for new and improved food
Palakiko. preparation training
techniques for all
employees
C—Take no action in 40% $1,000,000
response to possible new
regulation

Finally, Palakiko estimates that the cost of implementing risk response A is $201,250, and the
cost of implementing risk response B is $195,000.

Required:
1. Calculate the inherent risk for Palakiko.
2. Calculate the residual risk for Palakiko associated with each of the three risk response
alternatives A, B, and C.
3. Calculate the benefit for Palakiko associated with each of the three risk response
alternatives A, B, and C.
4. Calculate the net benefit for Palakiko associated with each of the three risk response
alternatives A, B, and C.
5. Using net benefit as the criterion, which risk response should Palakiko choose to
implement?

O BJE C T I V E 3 ▶
Brief Exercise 13-28 Quality Cost Report
Example 13.2 Loring Company had total sales of $2,400,000 for fiscal 20X1. The costs of quality-related ac-
tivities are given below.

Discounts due to defects $100,000

Retesting 30,000
Vendor certification 14,000
Rework 120,000
Marketing research 6,000
Process acceptance 14,000
Field testing 16,000
Product liability 200,000

Required:
1. Prepare a quality cost report, classifying costs by category and expressing each category as
a percentage of sales. What message does the cost report provide?
2. Prepare a bar graph and pie chart that illustrate each category’s contribution to total
quality costs. Comment on the significance of the distribution.

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 Chapter 13 Emerging Topics in Managerial Accounting 765

Brief Exercise 13-29 Interim Quality Performance Report OB J ECT I VE ◀ 3

Cassara, Inc., had the following quality costs for the years ended December 31, 20X1 and 20X2: Example 13.3

20X1 20X2
Prevention costs:
Design reviews $ 60,000 $ 83,000
Prototype inspection 120,000 168,000
Appraisal costs:
Field testing 90,000 126,000
Packaging inspection 75,000 106,000
Internal failure costs:
Scrap 100,000 76,200
Repairs 220,000 166,800
External failure costs:
Lost sales 160,000 122,000
Product liability 360,000 277,000

At the end of 20X1, management decided to increase its investment in control costs by 40% for
each category’s items, with the expectation that failure costs would decrease by 25% for each
item of the failure categories. Sales were $12,000,000 for both 20X1 and 20X2.

Required:
1. Calculate the budgeted costs for 20X2, and prepare an interim quality performance
report.
2. Comment on the significance of the report. How much progress has Cassara made?

Brief Exercise 13-30 Quality Trend Report OB J ECT I VE ◀ 3

Pintura Company implemented a quality improvement program and tracked the following for Example 13.4
the five years:

Quality Costs Actual Sales Costs as a Percentage of Sales

20X1 $750,000 $3,000,000 25.00%
20X2 690,000 3,000,000 23.00
20X3 680,000 3,400,000 20.00
20X4 510,000 3,400,000 15.00
20X5 480,000 4,000,000 12.00

By cost category as a percentage of sales for the same period of time:

Prevention Appraisal Internal Failure External Failure

20X1 1.00% 1.50% 9.50% 13.00%
20X2 2.00 2.00 8.50 10.50
20X3 2.50 3.00 7.50 7.00
20X4 3.00 3.50 4.50 4.00
20X5 3.50 3.50 2.50 2.50

Required:
1. Prepare a bar graph that reveals the trend in quality cost as a percentage of sales (time
on the horizontal axis and percentages on the vertical). Comment on the message of the
graph.
2. Prepare a bar graph for each cost category as a percentage of sales. What does this graph
tell you?

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766 Chapter 13 Emerging Topics in Managerial Accounting

O BJE C T I V E 4 ▶
Brief Exercise 13-31 Continuous Flow vs. Departmental Manufacturing
Example 13.5 Gumbrecht Company has the following departmental manufacturing layout for one of its
plants:

12 minutes 6 minutes
Wait time = 10 minutes Move and wait time = 15 minutes
Casting Grinding

Move and wait time = 25 minutes

10 minutes 2 minutes
Move and wait time = 20 minutes
Drilling Finishing

A consulting firm has recommended a value stream with the following manufacturing cell:

6 minutes 12 minutes

Grinding Casting

Drilling Finishing

10 minutes 2 minutes

Required:
1. Calculate the total time it takes to produce a batch of 20 units using the traditional
departmental manufacturing layout.
2. Using cellular manufacturing, how much time is saved producing the same batch of
20 units? Assuming the cell operates continuously, what is the production rate? Which
process controls this production rate?
3. Assume the processing time of Casting is reduced to 9 minutes, while the times of
the other processes stay the same. What is the production rate now, and how long
will it take to produce a batch of 20 units if the cell is in a continuous production
mode?

O BJE C T I V E 4 ▶
Brief Exercise 13-32 Continuous Flow vs. Departmental Manufacturing
Example 13.6 During the week of August 21, Parley Manufacturing produced and shipped 4,000 units
of its machine tools: 1,500 units of Tool SK1 and 2,500 units of Tool SK3. The cycle time
for SK1 is 0.73 hour, and the cycle time for SK3 is 0.56 hour. The following costs were
incurred:

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 Chapter 13 Emerging Topics in Managerial Accounting 767

Parley Manufacturing
Value-Stream Costs and Production Hours
This Week, August 21
Salaries/
Net Hours Materials Wages Machining Other Total Cost
Order processing 400 $ 4,500 $ 4,500
Production planning 50 9,000 9,000
Purchasing 200 6,750 6,750
Casting 500 $ 66,750 36,375 $ 9,000 $4,500 116,625
Grinding 600 25,000 10,500 10,500 3,000 49,000
Drilling 125 18,750 12,500 31,250
Inspection 150 2,625 2,625
Packaging and shipping 150 2,250 2,250
Invoicing 325 3,000 3,000
Totals 2,500 $110,500 $87,500 $19,500 $7,500 $225,000

Required:
1. Assume that the value-stream costs and total units shipped apply only to one model
(a single-product value stream). Calculate the unit cost, and comment on its accuracy.
2. Assume that Tool SK1 is responsible for 60% of the materials cost. Calculate the unit cost
for Tool SK1 and Tool SK3, and comment on its accuracy. Explain the rationale for using
units shipped instead of units produced in the calculation.
3. Calculate the unit cost for the two models, using DBC. Explain when and why this cost is
more accurate than the unit cost calculated in Requirement 2.

Brief Exercise 13-33 Exchange Gains and Losses OB J ECT I VE ◀ 5

On March 1, Friedle Import-Export Company sells merchandise costing 75,000 Mexican pesos. Example 13.7
Payment will be made in pesos, on June 1. The exchange rates of pesos for $1 were as follows:
March 1 $1 = 10.9 pesos
June 1 $1 = 11.4 pesos

Round all answers to the nearest dollar.

Required:
1. What is the receivable in dollars on March 1?
2. What is the dollar value of the amount paid in pesos on June 1?
3. If Friedle is paid on June 1, is there an exchange gain or loss? If so, how much is it?

EXERCISES
Exercise 13-34 Managing Risks Using a Portfolio Perspective OB J ECT I VE ◀ 1
Barolo Company manufactures laptop stickers for Italian sports teams. Barolo’s risk manage-
ment team has identified the company’s top five inherent risks and plans to manage them using
a typical ERM portfolio perspective (i.e., align the portfolio of residual risks with the company’s
risk appetite) . Specifically, the team has decided to accept inherent risk 2 (IR2) and inherent
risk 3 (IR3) as they approximately offset each other. The team also decided to accept inherent
risk 1 (IR1) because it is very close to the company’s risk appetite. In addition, the team decided

(Continued)

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768 Chapter 13 Emerging Topics in Managerial Accounting

to reduce inherent risk 4. Barolo’s risk graph shown below depicts its portfolio of risks after the
team has implemented its risk responses.

Impact

IR2

IR1
1

2 4

Required:
Refer to Barolo’s risk graph and match the numbers (c–g) on the graph with the correct let-
tered descriptions (A–G).
c= A. Inherent risk 3 (IR3)
d= B. Residual risk 4 (RR4)
e= C. Net benefit
f= D. Inherent risk 4 (IR4)
g= E. Likelihood
F. Board of directors
G. Risk appetite

O BJE C T I V E 1 ▶
Exercise 13-35 Managing Risks Using a Portfolio Perspective
Brunello Winery produces expensive wines. Brunello’s enterprise risk management team has
chosen its particular risk response to each of its top five inherent risks. The risk graph below
shows Brunello’s risks after all of the team’s risk responses have been enacted.

Impact

IR4

IR3
IR5
RR4

RR5

IR1

Likelihood

Required:
Refer to Brunello’s risk graph and determine the particular risk response alternative (Accept,
Avoid, or Reduce) that the team chose to implement for each of the company’s inherent risks 1
(IR1) through 5 (IR5).

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 Chapter 13 Emerging Topics in Managerial Accounting 769

Exercise 13-36 Using Net Benefit to Evaluate Risk Response Alternatives OB J ECT I VE ◀ 1
Crazy Fan Guard Company provides security services to popular live sporting event venues.
Crazy Fan management has identified one of its top risks as the possibility that restric-
tions on premium close seating options will severely decrease its sales revenue by lessen-
ing the demand for its security services. The table below displays a description of this top
risk, an inherent risk assessment, three risk response alternatives, and finally, a residual risk
assessment.

Inherent Risk Risk Response Residual Risk

Impact Impact
(on lost (on lost
Risk Likelihood revenues) Alternatives Likelihood revenues)
Premium close seating 25% $10,000,000 A—Invest in a business 10% $5,000,000
at future popular live process that focuses on
sporting events is managing improved fan
discontinued due to behavior at popular live
viewer outrage over sporting events
previous on-field security B—Form an alliance with 15% $10,000,000
violations (e.g., fans another security organization
rushing court or field and to more effectively (e.g.,
making physical contact quickly and forcefully)
with the athletes). remove fans who rush the
field
C—Take no action 25% $10,000,000

Crazy Fan Guard’s management accounting team estimates that the incremental cost of
implementing response A is $2,200,000, and the incremental cost of implementing response B
is $700,000.

Required:
1. Calculate the benefit of each risk response alternative A through C.
2. Calculate the net benefit of each risk alternative A through C.
3. CONCEPTUAL CONNECTION Using net benefit as the criterion, explain the best
risk response alternative that Crazy Fan Guard Company management should
implement.

Exercise 13-37 Incorporating Stakeholder Impacts into Business Sustainability OB J ECT I VE ◀

2
Analyses and Decisions
Jack’s Apps Company researches, develops, and sells traditional applications (i.e., apps) for
middle-aged mobile phone device users. In an attempt to tap into the large young adult app
market to boost sales and advertising revenues, Jack’s CFO, Daniel, is considering hiring
students from area high schools and universities to drastically increase the innovativeness of
the company’s apps. Specifically, Daniel hopes that Jack’s new student employee pool will make
Jack’s next wave of phone apps inventions popular with young adults by providing innovative
services, such as exchanging payments for late-night food deliveries, arranging informal dating
and other social gatherings, exchanging perspectives on different professors, and identifying
unusual debit card purchase patterns to assist with early fraud detection notification. Based
on cost estimates from Jack’s finance team and surveys of its new target customers (i.e., New
Customer Financial Survey), Daniel estimates that this new customer market would increase
Jack’s annual net income by $10,000,000.

(Continued)

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770 Chapter 13 Emerging Topics in Managerial Accounting

In addition to the New Customer Financial Survey, Jack’s management team conduct-
ed a Business Sustainability Analysis. Specifically, the stakeholder engagement portion of
the Business Sustainability Analysis revealed that four of Jack’s most important stakehold-
er groups (advertisers, regulators, employees, and customers) would react strongly—some
favorably and others unfavorably—to the decision to push its app business in the direction
of the young adult market. Specifically, ten percent of its existing advertisers would drop
Jack’s as a client, thereby reducing its annual advertising revenue of $10,000,000. Also,
confidential discussions with competitors suggest that the new fraud detection app would
require sensitive customer information that Jack’s would be unable to protect perfectly
from data hackers, thereby resulting in annual fines of $1,500,000 from regulators. In
addition, employee engagement meetings indicated that they would strongly favor the
expansion into the young adult market. Daniel estimates that improved employee morale
would significantly increase their productivity and creativity, thereby increasing annual
sales revenue by $2,000,000. Finally, focus groups with existing customers revealed that
they would highly value the increased workforce diversity of Jack’s hiring a large number
of talented young female employees with an expertise in technology. Daniel estimates that
this positive customer sentiment would translate into an additional $3,000,000 in annual
traditional apps sales.

Required:
1. Using the New Customer Financial Survey and the Business Sustainability Analysis,
calculate the net change in Jack’s Apps Company’s net income that would be expected
from pursuing the young adult app market.
2. Based on the calculation in Requirement 1, should Jack’s Apps pursue the young adult app
market? Explain your answer.
3. CONCEPTUAL CONNECTION Describe two additional considerations that Jack’s Apps
Company management might be wise to consider before making a final decision on
whether or not to pursue the young adult apps market.

O BJE C T I V E 2 ▶
Exercise 13-38 Stakeholder Engagement in Business Sustainability
Apple Inc. is a multinational technology company that designs, develops, manufac-
tures, and sells innovative consumer electronics products and services around the globe.
Its products include laptop (e.g., MacBook) and desktop (e.g., iMac) computers, mobile
phones (e.g., iPhone), MP3 players (e.g., iPod nano), tablets (e.g., iPad), and various other
devices (e.g., Apple Watch, Apple TV, etc.). Its services include personalized, onsite (e.g.,
at Apple Store) group and individual training sessions, fitness notifications (e.g., from
Apple Watch), audio and video streaming, and online and phone help services. Founded
in Cupertino, California, in 1976, Apple has been a success as measured by almost any
standard. As one example, Apple recently reported the largest ever recorded quarterly
profit by a single public corporation! While a history of such amazing performance is
admirable, publicly traded companies must always focus on the future and convince inves-
tors, and various other key stakeholders, that they will maintain—or even improve—per-
formance in the future.

Required:
1. CONCEPTUAL CONNECTION Identify the five most important stakeholders for Apple
Inc. Briefly explain how you selected these five stakeholders and why they are important
to Apple.
2. CONCEPTUAL CONNECTION Describe the specific approach you believe Apple’s
management team should employ to engage with each of the five stakeholders you
identified in Requirement 1. For each stakeholder engagement approach, briefly explain

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 Chapter 13 Emerging Topics in Managerial Accounting 771

the type of information or performance measures that Apple’s management team should
provide to the stakeholder (or receive from the stakeholder) to improve the effectiveness
of the engagement.

Exercise 13-39 Linking Risk Management and Performance Measurement in OB J ECT I VE ◀ 2

Business Sustainability
Princeville Paradise Ice Cream Shoppe manufactures and sells premium ice cream in a unique
Hawaiian environment. Princeville Paradise’s management performed a stakeholder engage-
ment exercise to identify its most important stakeholders, given its strategy to “Provide tour-
ists and residents with the best ice cream experience in the islands.” The exercise revealed that
Princeville Paradise’s top four stakeholders are customers, employees, local suppliers, and
regulators.

Required:
1. CONCEPTUAL CONNECTION For each stakeholder, list and briefly describe a risk that
the stakeholder poses to Princeville Paradise achieving its strategy.
2. CONCEPTUAL CONNECTION For each risk described in Requirement 1, list and briefly
describe one nonfinancial performance metric that Princeville Paradise management should
use to measure how effectively this associated risk is being managed.
3. CONCEPTUAL CONNECTION For each nonfinancial performance metric in
Requirement 2, list and briefly describe one financial performance metric that Princeville
Paradise management should use to measure in financial terms (i.e., to investors)
how the management of the associated risk ultimately affects the company’s financial
performance.

Exercise 13-40 Quality Cost Classification OB J ECT I VE ◀ 3

Classify the following quality costs as prevention costs, appraisal costs, internal failure costs, or
external failure costs:
1. Scrap (created by defective units)
2. Certifying a vendor to ensure that quality parts are provided
3. Stopping work to control process malfunction
4. Replacing a defective product for a customer
5. Goods returned because they were defective
6. Inspecting a subassembly
7. Inspecting and testing prototypes
8. Reinspecting a reworked product
9. Packaging inspection
10. Lost sales because of recalled products
11. Recall to repair defective products
12. Process acceptance
13. Internal audit to ensure that quality guidelines and processes are being followed
14. Repairing products in the field
15. Providing engineering assistance to selected suppliers to improve their product quality
16. Correcting a design error discovered during product development
17. Settling a bodily injury lawsuit caused by a defective product
18. Customer complaint department
19. Quality control circles
20. Continuing supplier verification
21. Redesigning a product to eliminate a product defect
22. Lost sales because of product quality concerns

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772 Chapter 13 Emerging Topics in Managerial Accounting

O BJE C T I V E 3 ▶
Exercise 13-41 Quality Cost Report
Bradshaw Company reported sales of $5,000,000 in 20X1. At the end of the fiscal year ( June
30, 20X1), the following quality costs were reported:

Vendor certification $ 43,500

Warranty 100,000
Rework 125,000
Field testing 54,000
Quality training 56,500
Process acceptance 40,000
Scrap 75,000
Recalls 90,000
Product inspection 46,000
Returned goods 70,000

Required:
1. Prepare a quality cost report.
2. Prepare a graph (pie chart or bar graph) that shows the relative distribution of quality
costs, and comment on the distribution.
3. Assuming sales of $5,000,000, by how much would profits increase if quality improves so
that quality costs are only 3% of sales?

O BJE C T I V E 3 ▶
Exercise 13-42 Multiple-Year Trend Reports
The controller of Emery, Inc. has computed quality costs as a percentage of sales for the past
5 years (20X1 was the first year the company implemented a quality improvement program).
This information is as follows:

Internal External
Prevention Appraisal Failure Failure Total
20X1 1% 3% 9% 12% 25%
20X2 3 4 7 9 23
20X3 4 5 4 6 19
20X4 5 4 3 5 17
20X5 6 3 1 2 12

Required:
1. Prepare a trend graph for total quality costs. Comment on what the graph has to say about
the success of the quality improvement program.
2. Prepare a graph that shows the trend for each quality cost category. What does the graph
have to say about the success of the quality improvement program? Does this graph supply
more insight than the total cost trend graph does?
3. Prepare a graph that compares the trend in relative control costs versus relative failure
costs. Comment on the significance of this trend.

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 Chapter 13 Emerging Topics in Managerial Accounting 773

Exercise 13-43 Traditional vs. Cellular Manufacturing OB J ECT I VE ◀ 4

Erba Inc. has the following departmental layout for producing an herbal supplement:

12 minutes 7 minutes
Wait time = 14 minutes Move and wait time = 15 minutes
Mixing Heating

Move and wait time = 30 minutes

6 minutes 5 minutes
Move and wait time = 25 minutes
Encapsulating Bottling

After a detailed study, the head of the plant’s industrial engineering department recommended
that the following cellular manufacturing layout replace the current departmental structure:

7 minutes 12 minutes

Grinding Mixing

Encapsulating Bottling

6 minutes 5 minutes

Required:
1. Calculate the time required to produce a batch of 12 bottles using a batch processing
departmental structure.
2. Calculate the time to process 12 units using cellular manufacturing.
3. How much manufacturing time will the cellular manufacturing structure save for a batch
of 12 units?
4. How many units can the cell produce per hour, assuming the cell is producing on a
continuous basis?
5. What must happen so that the cell can produce 12 units per hour, assuming the cell
produces on a continuous basis?

Exercise 13-44 Value-Stream Average Costing, ABC, DBC OB J ECT I VE ◀ 4

A value stream has three activities and two products. The units produced and shipped per week
are 50 of the limited model (Model K), characterized by special additional features, and 150 of
the regular model (Model R), with only basic features. The conversion cost resource consump-
tion patterns are shown as follows:

Model K Model R Costs of Value-Stream Activities

Cell manufacturing 2,700 minutes 2,100 minutes $19,200
Engineering 65 hours 15 hours 3,400
Testing 25 hours 55 hours 3,000
Total $25,600

(Continued)
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774 Chapter 13 Emerging Topics in Managerial Accounting

Required:
1. Calculate the ABC product cost (conversion cost) for Models K and R.
2. Calculate the value-stream average product cost (conversion cost). Assuming reasonable
stability in the consumption patterns of the products and product mix, assess how well
the products are grouped, based on similarity.
3. Calculate the cycle time for each product by dividing the total hours used for each
product by the units produced of each product. Now calculate the DBC cost for each
product. Comment on the significance of DBC for this setting.

O BJE C T I V E 4 ▶
Exercise 13-45 Box Scorecard
A Box Scorecard was prepared for a value stream:

This Week Planned Future State

Last Week (1/7/20X1) (12/31/20X1)
Operational
Units sold per person 150 162 175
On-time delivery 80% 85% 96%
Dock-to-dock days 10 9 8
First-time through 70% 73% 85%
Average product cost $100 $99 $97
Capacity
Productive 35% 36% 37%
Nonproductive 60% 67% 45%
Available 15% 17% 38%
Financial
Weekly sales $1,200,000 $1,237,500 $1,400,000
Weekly material cost $480,000 $495,000 $570,000
Weekly conversion cost $420,000 $420,360 $460,000
Weekly value-stream profit $300,000 $325,000 $450,000
ROS 25% 26% 32%

Required:
1. How many nonfinancial measures are used to evaluate performance? Why are
nonfinancial measures used?
2. Classify the operational measures as time-based, quality-based, or efficiency-based.
Discuss the significance of each category for lean manufacturing.
3. What is the role of the Planned Future State column?
4. Discuss the capacity category and explain the meaning of each measure and its
significance.
5. Discuss the relationship between the financial measures and the measures in the
operational and capacity categories.

O BJE C T I V E 5 ▶
Exercise 13-46 Types of Involvement in International Trade
Match each term in Column A with its related definition in Column B.
Column A
1. Maquiladora
2. Import
3. Joint venture
4. Export
5. MNC

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 Chapter 13 Emerging Topics in Managerial Accounting 775

Column B
a. A company that does business in more than one country in such volume that its well-
being and growth rest in more than one country.
b. A company purchases materials or parts from another company that is located in a foreign
country.
c. A company sells its product to purchasers located in foreign countries.
d. A type of partnership in which investors from one country co-own the enterprise with
investors from another country.
e. A manufacturing plant located in Mexico that processes imported materials and reexports
them to the United States.

Exercise 13-47 Foreign Currency Exchange OB J ECT I VE ◀ 5

Match each term in Column A with its related definition in Column B.
Column A
1. Spot rate
2. Currency appreciation
3. Translation risk
4. Transaction risk
5. Exchange rate
Column B
a. The rate at which one currency can be traded for another currency.
b. The possibility that future cash transactions will be affected by changing exchange rates.
c. A month ago, $1 U.S. was worth 8.5 Mexican pesos. Today, $1 is worth 9.0 Mexican
pesos. The U.S. dollar has undergone what?
d. The degree to which a firm’s financial statements are exposed to exchange rate
fluctuation.
e. The exchange rate of one currency for another for immediate delivery (today).

Exercise 13-48 Payment of Duty and Duty-Related Carrying Cost OB J ECT I VE ◀ 5

Kamber, Inc., owns a factory located close to, but not inside, a foreign trade zone. The plant
imports volatile chemicals that are used in the manufacture of chemical reagents for laborato-
ries. Each year, Kamber imports about $14,200,000 of chemicals subject to a 30% tariff when
shipped into the United States. About 15% of the imported chemicals are lost through evap-
oration during the manufacturing process. In addition, Kamber has a carrying cost of 10% per
year associated with the duty payment. On average, the chemicals are held in inventory for
9 months.

Required:
1. How much duty is paid annually by Kamber?
2. What is the carrying cost associated with the payment of duty?

Exercise 13-49 Payment of Duty and Duty-Related Carrying Cost OB J ECT I VE ◀ 5

Refer to Exercise 13-48. Suppose that Kamber is considering building a new plant inside a for-
eign trade zone to replace its chemical manufacturing plant.

Required:
1. How much duty will be paid per year by the factory located inside the foreign trade zone?
2. How much in duty and duty-related carrying costs will be saved by relocating inside the
foreign trade zone?

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776 Chapter 13 Emerging Topics in Managerial Accounting

O BJE C T I V E 6 ▶
Exercise 13-50 Fraud Concepts
Consider each of the following situations. Is there a potential problem? Which part of the fraud
triangle is involved, if any?
A. Susan is an accounts payable clerk. She sets up creditors in a financial database and pays
invoices as they come in. Last year, she won employee of the year and is a valued employee.
Through the grapevine, Susan’s boss just learned that Susan’s brother has a gambling
problem.
B. Now suppose that Susan from situation A is now secretary for the head of the marketing
department. She keeps track of the vice president of marketing’s schedule and handles the
correspondence.
C. Keith has been employed for 6 months as a teller at a community bank. All is going well,
and his cash drawer has had shortages only twice (of less than $10). The shortages were
traced and the problems corrected.
D. At the company Memorial Day picnic and golf outing last week, Nancy notice that June
moved her ball to a better lie when she thought no one was looking. There were no prizes
for a low score, and June did not benefit from the lower score that resulted.

PROBLEMS

O BJE C T I V E 1 ▶
Problem 13-51 Using Net Benefit to Evaluate Risk Response Alternatives
Rocket Motors manufactures sterndrive engines for pleasure craft boats. Rocket’s man-
agement is concerned about increasing competition in its industry, resulting from a very
large international boat motor manufacturer that appears to be seriously considering
entering the same customer market served by Rocket. Specifically, management is most
worried about the sales revenue it might lose should this international competitor enter
Rocket’s market. The chart below contains a description of Rocket’s top risk, an inherent
risk assessment, three risk response alternatives, and a residual risk assessment for each
response alternative.

Inherent Risk Risk Response Residual Risk

Impact Impact
(on lost (on lost
Risk Likelihood revenues) Alternatives Likelihood revenues)
A large international 50% $60,000,000 A—Sign long-term sales 25% $50,000,000
competitor enters the same contracts with its five
market served by Rocket, biggest customers before
thereby significantly the competitor enters the
decreasing Rocket’s annual market
sales revenue. B—Invest in a new quality 40% $15,000,000
program to significantly
increase the performance
and quality of its engines
beyond the level achieved
by the new competitor
C—Take no action in 50% $60,000,000
response to possible new
regulation

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 Chapter 13 Emerging Topics in Managerial Accounting 777

Finally, Rocket’s management accounting team estimates that Rocket would need to spend
$10,000,000 in product giveaways on each of its five biggest customers in order to convince
them to sign long-term sales contracts with Rocket. Also, the team believes that Rocket would
incur $8,500,000 in additional sales staff travel to complete the long-term contracts. Further,
the team estimates that the new quality program would cost $15,000,000 in order to attain
the higher level of performance quality necessary to set Rocket apart from its potential new
competitor. Finally, Rocket forecasts that it would need to spend an additional $5,000,000 on
advertising to sufficiently spread the word to customers regarding its significantly improved per-
formance quality.

Required:
1. Calculate the net benefit for each of Rocket’s three risk response alternatives (A, B, and C)
under consideration.
2. CONCEPTUAL CONNECTION Which risk response alternative should Rocket select?
Explain your reasoning.
3. CONCEPTUAL CONNECTION Under what conditions would risk response alternative C
be the preferred alternative?

Problem 13-52 Incorporating Stakeholder Impacts into Business Sustainability OB J ECT I VE ◀ 2

Analyses and Decisions
Stylz Company, a recent start-up fashion retailer based in the United States, is deciding between
opening its first sales presence in either Italy’s Tuscany Region or Spain’s Matarrana Region.
Stylz’s financial group surveyed potential customers in both markets and has compiled a busi-
ness plan that estimates the financial impact for the first 5 years. This 5-year financial plan es-
timates that entering Tuscany would generate $9,000,000 of operating income for Stylz in the
first year, which would increase by 10% per year throughout the plan period. The plan also
estimates that entering Matarrana would generate $5,000,000 of operating income for Stylz in
the first year, which would increase by 50% per year throughout the plan period.
In addition, after completing its 5-year financial plan focusing on operating income, Stylz’s
management decided also to conduct a business sustainability analysis. Based on Stylz’s strate-
gy, management identified the company’s four most important stakeholders for its initial sales
region decision to be suppliers, employees, regulators, and the local community (in addition to
investors and customers whose insights drove the results of the 5-year financial plan). The results
of management’s stakeholder engagement analysis, including additional insights with respect to
how each stakeholder is expected to impact Stylz’s performance measures, are as follows:
Suppliers: Suppliers carry out the sourcing of Stylz’s products in the chosen sales region.
The existing supplier network in Tuscany is mature and already works with other fashion com-
panies in the region; thus, Stylz could connect with this supplier network at a negligible cost.
However, the existing supplier network in Matarrana is much less established because there are
fewer competing fashion retailers in the region. While less competition offers greater growth
opportunities for Stylz, the Matarrana region’s less established supplier network will require
Sytlz to spend approximately $5,000,000 during each of its first 2 years in the region in order to
create adequate supply chain quality and reliability.
Employees: Employees affect the existence and quality of Stylz’s workforce in the new sales
region. The stakeholder engagement interaction revealed that the regions have a very similar
cost of living (and, therefore, very similar wage rates), as well as sufficient numbers of poten-
tial hourly store employees. However, the Tuscany region has significantly fewer potential store
managers. As a result, Stylz expects that choosing Tuscany would lead the company to spend an
additional $2,000,000 annually to train and develop its store managers that it would not need
to spend if it chose the Matarrana region.
Regulators: Regulators affect the cost of Stylz complying with any applicable existing or
new regulations. The stakeholder engagement sessions revealed an atmosphere of growing pres-
sure on regulators to increase the number of environmental regulations for companies operating
(Continued)
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778 Chapter 13 Emerging Topics in Managerial Accounting

in the region. Stylz management estimates that it would need to spend $1,000,000 annually in
the Tuscany region to comply with these fully expected new environmental regulations that it
would not face in the Matarrana region. Alternately, stakeholder engagement sessions in the
Matarrana region revealed a surprisingly lax atmosphere in which it is commonplace to pay
bribes to secure deals and contracts with various necessary business partners in the region. As a
result, Stylz management estimates that it would need to spend an additional $3,000,000 annu-
ally on training its own employees, as well as many of its business partners, on how to conduct
business ethically and in compliance with the Foreign Corrupt Practices Act (FCPA, which is
required for all U.S.-based companies). This training would help the company avoid intentional
or unintentional unethical activity. Stylz management does not believe it would need to incur
this additional FCPA training cost if it chose Tuscany.
Local Community: The local community reflects the general attitude of the underlying
population toward a particular company and its policies. Stakeholder engagement sessions sug-
gested that Stylz generally would have the support of the Tuscan community. However, these
sessions also revealed a strong undercurrent of resentment among many local residents in the
Matarrana region from those residents who do not want a U.S.-based fashion retailer placing
its economic, social, or environmental footprint within its community. However, Stylz man-
agement believes that its footprint will be significantly positive as it will hire and train local
workers, give back to the community through various programs and new community parks,
and employ state-of-the-art environmental policies throughout its value chain that will have a
net-zero impact on the environment. Stylz management estimates that it would need to spend
$1,500,000 each year to convince the Matarrana community of its significantly positive foot-
print. In addition, if the Matarrana region is chosen, Stylz management believes it would need
to spend an additional $3,500,000 in the first year only in order to win the approval of the most
influential activist group in the community.

Required:
1. Considering only the results of Stylz financial group’s initial 5-year financial plan (i.e.,
ignore the business sustainability analysis for this requirement), estimate the operating
income over the 5-year period for each sales region—Tuscany and Matarrana. Based
solely on the operating income from this 5-year financial plan, which region should Stylz
Company management select in order to maximize its estimated total operating income?
Explain your answer.
2. Next consider only the results of Stylz management’s business sustainability analysis
(i.e., ignore the 5-year financial plan for this requirement) that incorporated the
findings from the stakeholder engagement sessions with Stylz’s four key stakeholders—
suppliers, employees, regulators, and the local community. Based solely on this business
sustainability analysis, estimate the impact that the four stakeholders would have on Stylz
Company’s operating income over the 5-year period. Explain your answer.
3. Now considering both the initial 5-year financial plan AND the business sustainability
analysis, estimate the total operating income over the 5-year period for each sales region.
Based on this combined analysis, which region should Stylz Company management select
in order to maximize its estimated total operating income over the 5-year period? Explain
your answer.
4. CONCEPTUAL CONNECTION Identify one important qualitative factor that you believe
Stylz management should consider in making its initial sales region decision. Explain how
this qualitative factor could potentially change your quantitative answer to Requirement 3.

O BJE C T I V E 2 ▶
Problem 13-53 Creating Corporate Sustainability Reports
Dorsey Scott MU Company manufactures and bottles a collection of health-oriented fruity
beverages. Dorsey’s CFO, Rozella, recently signed a series of new contracts with several dozen
large universities to serve as the sole external beverage supplier on these campuses. Although
the company has never internally conducted or externally disclosed any sustainability activi-
ties, Dorsey’s CEO, Les, has a strong hunch that the company would be wise to look into the
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 Chapter 13 Emerging Topics in Managerial Accounting 779

idea of sustainability, given its recent significant growth in the university market. Therefore, Les
and Rozella assigned Dorsey’s team of five interns to spend their summer internships creating
Dorsey’s first corporate sustainability report.

Required:
1. CONCEPTUAL CONNECTION Briefly explain the most likely reason(s) that Les believes
Dorsey would be wise to begin looking into sustainability at this time.
2. CONCEPTUAL CONNECTION List and describe three challenges that the internship
team might face in creating Dorsey’s first corporate sustainability report.
3. CONCEPTUAL CONNECTION List and describe three benefits that Dorsey or its key
stakeholders might enjoy as a result of Dorsey creating and issuing its first corporate
sustainability report.

Problem 13-54 Quality Cost Summary OB J ECT I VE ◀ 3

Danna Wise, president of Tidwell Company, recently returned from a conference on quality
and productivity. At the conference, she was told that many American firms have quality costs
totaling 20 to 30% of sales. The quality experts at the conference convinced her that a company
could increase its profitability by improving quality. However, she was of the opinion that the
quality of Tidwell Company was much less than 20%—probably more in the 4 to 6% range.
However, because the potential for increasing profits was so great if she was wrong, she decided
to request a preliminary estimate of the total quality costs currently being incurred. She asked
her controller for a summary of quality costs, with the costs classified into four categories: pre-
vention, appraisal, internal failure, or external failure. She also wanted the costs expressed as a
percentage of both sales and profits. The controller had his staff assemble the following informa-
tion from the past year, 20X1:
a. Sales revenue, $37,240,000; net income, $4,000,000.
b. During the year, customers returned 40,000 units needing repair. Repair cost averages
$9 per unit.
c. Twelve inspectors are employed, each earning an annual salary of $80,000. The inspectors
are involved only with final inspection (product acceptance).
d. Total scrap is 200,000 units. Of this total, ninety percent is quality related. The cost of
scrap is about $10 per unit.
e. Each year, approximately 800,000 units are rejected in final inspection. Of these units,
seventy-five percent can be recovered through rework. The cost of rework is $1.80 per
unit.
f. A customer cancelled an order that would have increased profits by $600,000. The
customer’s reason for cancellation was poor product performance.
g. The company employs 10 full-time employees in its complaint department. Each earns
$48,600 a year.
h. The company gave sales allowances totaling $180,000 due to substandard products being
sent to the customer.
i. The company requires all new employees to take its 4-hour quality training program. The
estimated annual cost of the program is $120,000.

Required:
1. Prepare a simple quality cost report classifying costs by category.
2. Compute the quality cost-sales ratio. Also, compare the total quality costs with total
profits. Should Danna be concerned with the level of quality costs?
3. Prepare a pie chart for the quality costs. Discuss the distribution of quality costs among
the four categories. Are they properly distributed? Explain.

(Continued)

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780 Chapter 13 Emerging Topics in Managerial Accounting

4. Discuss how the company can improve its overall quality and at the same time reduce
total quality costs.
5. By how much will profits increase if quality costs are reduced to 3% of sales?

O BJE C T I V E 3 ▶ Problem 13-55 Quality Cost Performance Reporting; One-Year Trend, Long-
Range Analysis
In 20X2, Clarkson Inc. initiated a full-scale, quality improvement program. At the end of the
year, Tony Ming, the president, noted with some satisfaction that the defects per unit of product
had dropped significantly compared to the prior year. He was also pleased that relationships
with suppliers had improved and defective materials had declined. The new quality training
program was also well accepted by employees. Of most interest to the president, however, was
the impact of the quality improvements on profitability. To help assess the dollar impact of the
quality improvements, the actual sales and the actual quality costs for 20X1 and 20X2 are as
follows by quality category:

20X1 20X2
Sales $12,000,000 $15,000,000
Appraisal costs:
Packaging inspection 480,000 450,000
Product acceptance 60,000 42,000
Prevention costs:
Quality circles 6,000 60,000
Design reviews 3,000 30,000
Quality improvement projects 3,000 150,000
Internal failure costs:
Scrap 420,000 360,000
Rework 540,000 480,000
Yield losses 240,000 150,000
Retesting 300,000 240,000
External failure costs:
Returned materials 240,000 240,000
Allowances 180,000 210,000
Warranty 600,000 660,000

All prevention costs are fixed (by discretion). Assume all other quality costs are unit-level
variable.

Required:
1. Compute the relative distribution of quality costs for each year and prepare a pie chart.
Do you believe that the company is moving in the right direction in terms of the balance
among the quality cost categories? Explain.
2. Prepare a 1-year trend performance report for 20X2 (comparing the actual costs of 20X2
with those of 20X1, adjusted for differences in sales volume). How much have profits
increased because of the quality improvements made by Clarkson Inc.?
3. Estimate the additional improvement in profits if Clarkson Inc. ultimately reduces its
quality costs to 3% of sales revenues (assume sales of $15 million).

O BJE C T I V E 3 ▶
Problem 13-56 Trend Analysis, Quality Costs
In 20X1, Don Blackburn, president of Price Electronics, received a report indicating that qual-
ity costs were 31% of sales. Faced with increasing pressures from imported goods, Don resolved
to take measures to improve the overall quality of the company’s products. After hiring a con-
sultant in 20X1, the company began an aggressive program of total quality control. At the end

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 Chapter 13 Emerging Topics in Managerial Accounting 781

of 20X5, Don requested an analysis of the progress the company had made in reducing and
controlling quality costs. The accounting department assembled the following data:

Internal External
Sales Prevention Appraisal Failure Failure
20X1 $1,000,000 $ 10,000 $20,000 $160,000 $120,000
20X2 1,200,000 50,000 30,000 120,000 100,000
20X3 1,400,000 70,000 60,000 70,000 50,000
20X4 1,200,000 80,000 30,000 50,000 40,000
20X5 1,000,000 100,000 10,000 24,000 16,000

Required:
1. Compute the quality costs as a percentage of sales by category and in total for each year.
2. Prepare a multiple-year trend graph for quality costs, both by total costs and by category.
Using the graph, assess the progress made in reducing and controlling quality costs. Does
the graph provide evidence that quality has improved? Explain.
3. Using the 20X1 quality cost relationships (assume all costs are variable), calculate the
quality costs that would have prevailed in 20X4. By how much did profits increase in
20X4 because of the quality improvement program? Repeat for 20X5.

Problem 13-57 Value-Stream Product Costing, ABC, and DBC OB J ECT I VE ◀ 4

Brasher Company is transitioning to a lean manufacturing system and has just finalized two or-
der fulfillment value streams. One of the value streams has two products, and the other has four
products. The two-product value stream produces precision machine parts and the four-product
value stream produces machine tools. Before moving to the value-stream structure, Brasher had a
well-developed ABC system (one that used all duration drivers) and had experienced good success
with the more accurate product costs. Management wanted to be sure that the average costing
approach of value-stream costing did not produce distorted product costs. Accordingly, expect-
ed weekly activity data were provided for the two-product value streams to see how well average
costing worked (see below); however, management did not want to continue using ABC because
of its intense data demands and the cost of updating as changes unfolded due to lean practices. In
the table below, the driver for each activity is a duration driver. Order processing, for example, uses
hours available for processing orders; purchasing uses hours available for processing purchases, etc.

Machine Parts Value Stream

For the Coming Week
Conversion Part M15 Part M78 Total Activity
Activity Cost (hours used) (hours used) Hours
Order processing $ 36,000 600 1,800 2,400
Purchasing 72,000 200 300 500
Lathe 108,000 480 320 800
Milling 200,000 800 1,200 2,000
Drilling 144,000 720 1,680 2,400
Assembly 40,000 1,200 800 2,000
Inspection 20,000 800 200 1,000
Shipping 18,000 600 200 800
Invoicing 32,000 700 800 1,500
Totals $670,000 6,100 7,300 13,400

During the week, the machine parts value stream expects to produce and ship 10,000 units of
M15 and 30,000 units of M78. Since materials cost is calculated separately, the main concern is
with the unit conversion cost.
(Continued)
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782 Chapter 13 Emerging Topics in Managerial Accounting

Required:
1. Calculate the average unit conversion cost for the two machine parts.
2. Calculate the conversion cost per unit for each part, using ABC. Comparing ABC unit
cost with the average cost, what would you recommend?
3. Calculate the conversion cost per unit, using DBC (first calculating the cycle time for
each product). Based on this outcome, what would you recommend to the management
of Brasher Company?

O BJE C T I V E 4 ▶
Problem 13-58 Box Scorecard
Merkley Company, a manufacturer of machine parts, implemented lean manufacturing at
the end of 20X1. Three value streams were established: one for new product development
and two order fulfillment value streams. One of the value streams set a goal to increase
its ROS to 45% of sales by the end of the year. During the year, the value stream made
significant improvements in several areas. The Box Scorecard below was prepared, with
performance measures for the beginning of the year, midyear, and end of year. Although
the members of the value stream were pleased with their progress, they were disappointed
in the financial results. They were still far from the targeted ROS of 45%. They were also
puzzled as to why the improvements made did not translate into significantly improved
financial performance.

December 31,
January 1, 20X2 June 30, 20X2 20X2
Operational
Revenue per person $25,000 $25,000 $25,000
On-time delivery 78% 85% 93%
Dock-to-clock days 13 8 6
First-time through 70% 70% 92%
Average product cost $90 $90 $88.50
Capacity
Productive 42% 42% 42%
Nonproductive 48% 30% 12%
Available 10% 28% 46%
Financial
Weekly sales $1,200,000 $1,200,000 $1,200,000
Weekly material cost $390,000 $390,000 $360,000
Weekly conversion cost $450,000 $450,000 $450,000
Weekly value-stream profit $360,000 $360,000 $390,000
ROS 35% 35% 38%

Required:
1. From the scorecard, what was the focus of the value-stream team for the first 6 months?
The second 6 months? What are the implications of these changes?
2. Using information from the scorecard, offer an explanation for why the financial results
were not as good as expected.

O BJE C T I V E 5 ▶
Problem 13-59 Exporting, Maquiladoras, Foreign Trade Zones
Paladin Company manufactures plain paper fax machines in a small factory in Minnesota.
Sales have increased by 50% in each of the past 3 years, as Paladin has expanded its market
from the United States to Canada and Mexico. As a result, the Minnesota factory is at capacity.
Beryl Adams, president of Paladin, has examined the situation and developed the following
alternatives:

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 Chapter 13 Emerging Topics in Managerial Accounting 783

1. Add a permanent second shift at the plant. However, the semiskilled workers who
assemble the fax machines are in short supply, and the wage rate of $15 per hour would
probably have to be increased across the board to $18 per hour in order to attract
sufficient workers from out of town. The total wage increase (including fringe benefits)
would amount to $125,000. The heavier use of plant facilities would lead to increased
plant maintenance and small tool cost.
2. Open a new plant and locate it in Mexico. Wages (including fringe benefits) would
average $3.50 per hour. Investment in plant and equipment would amount to $300,000.
3. Open a new plant and locate it in a foreign trade zone, possibly in Dallas. Wages would
be somewhat lower than in Minnesota, but higher than in Mexico. The advantages of
postponing tariff payments on imported parts could amount to $50,000 per year.

Required:
Advise Beryl of the advantages and disadvantages of each of her alternatives.

Problem 13-60 Currency Exchange Rates OB J ECT I VE ◀ 5

Custom Shutters, Inc., manufactures plantation shutters according to customer order. The com-
pany has a reputation for producing excellent quality shutters that fit virtually any size or shape
of window. Sales are made in all 50 states. On July 1, Custom Shutters received orders from
contractors in Switzerland and Japan. Lee Mills, president and co-owner of Custom Shutters,
was delighted. The Swiss order is for shutters priced at $64,000. The order is due in Geneva on
September 1, with payment due in full on October 1. The Japanese order is for shutters priced at
$124,000. It is due in Tokyo on August 1, with payment due in full on October 1. Both orders
are to be paid in the customer’s currency. The Swiss customer has a reputation in the industry for
late payment, and it could take as long as 6 months. Lee has never received payment in foreign
currency before. He had his accountant prepare the following table of exchange rates:

Exchange Rate for $1

Swiss Franc Yen
Spot rate 1.2360 117.70
30-Day forward rate 1.2450 117.68
90-Day forward rate 1.2590 117.70
180-Day forward rate 1.2708 117.66

Required:
1. If the price of the shutters is set using the spot rate as of July 1, how many francs does Lee
expect to receive on October 1? How many yen does he expect on October 1?
2. Using the number of francs and yen calculated in Requirement 1, how many dollars does
Lee expect to receive on October 1? Will he receive that much? What is the value of
hedging in this situation?
Problem 13-61 Forensic Accounting and Business Valuation OB J ECT I VE ◀ 6
You have just opened your own printing business. A large sports franchise is beginning an important
advertising campaign in order to attract more fans to the sport. The purchasing officer of the compa-
ny calls and asks you to make a bid on printing 5,000 high-quality posters that are to be given out to
important boosters. He asks you to come by his office to talk about the job. There, he tells you that
he would like to help you get started in your new business. He says that he has already asked for bids,
and the lowest is for $25,000. He continues by suggesting that you come in with a bid for $24,000
and give him $500 in cash so that you get the bid. Your immediate reaction is to be flattered because
you know that this could lead to many more contracts. You go back to your office and calculate your
costs. You are pleased to see that you will make about $6,000 on the project, which you really need.

Required:
Is the deal suggested by the purchasing officer fraud? Explain.

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784 Chapter 13 Emerging Topics in Managerial Accounting

CASES
O BJE C T I V E 2 ▶
Case 13-62 Examining Corporate Sustainability Reports
Corporate sustainability reports vary greatly across companies and industries. Select two com-
panies that interest you and conduct an online search to find their corporate sustainability re-
port. (If one or both of the companies you selected do not issue a corporate sustainability report,
then select a different company that does issue such a report.) You can either scroll through the
corporate sustainability reports for the two companies you selected or you can download them
onto your computer and scroll through the downloaded reports.

Required:
1. Identify and briefly explain three similarities between the two corporate sustainability
reports.
2. Identify and briefly explain three differences between the two corporate sustainability
reports.
3. CONCEPTUAL CONNECTION What do you believe is the greatest strength of each
corporate sustainability report?
4. CONCEPTUAL CONNECTION What do you believe is the greatest weakness of each
corporate sustainability report?
5. CONCEPTUAL CONNECTION Assume that you are able to provide the executive team
at each company with one suggestion for improving its next corporate sustainability report.
Briefly explain your suggestion for each company’s executive team.

O BJE C T I V E 3 ▶
Case 13-63 Quality Cost Performance Reports
Luna Company is a printing company and a subsidiary of a large publishing company. Luna is
in its fourth year of a 5-year, quality improvement program. The program began in 20X1 as a
result of a report by a consulting firm that revealed that quality costs were about 20% of sales.
Concerned about the level of quality costs, Luna’s top management began a 5-year plan in 20X1
with the objective of lowering quality costs to 10% of sales by the end of 20X5. Sales and quality
costs for each year are as follows:

Sales Revenues Quality Costs

20X1 $30,000,000 $6,000,000
20X2 30,000,000 5,400,000
20X3 33,000,000 5,445,000
20X4 33,857,000 4,740,000
20X5 36,000,000 3,960,000

Quality costs by category are expressed as a percentage of sales as follows:

Prevention Appraisal Internal Failure External Failure

20X1 1.0 % 2.0 % 7.0 % 10.0 %
20X2 2.0 3.0 6.0 7.0
20X3 2.5 4.0 4.0 6.0
20X4 3.0 4.0 3.5 3.5
20X5 3.5 3.5 2.0 2.0

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 Chapter 13 Emerging Topics in Managerial Accounting 785

The detail of the 20X5 budget for quality costs is also provided.

Quality planning $ 450,000

Quality training 180,000
Quality improvement (special project) 430,000
Quality reporting 260,000
Proofreading 860,000
Other inspection 480,000
Correction of typos 375,000
Plate revisions 125,000
Press downtime 221,000
Waste (because of poor work) 125,000
Returns/allowances 450,000
Lost sales 235,000
Rework (because of customer complaints) 195,000
Total quality costs $4,386,000

Actual quality costs for 20X4 and 20X5 are as follows:

20X5 20X4
Quality planning $450,000 $440,000
Quality training 160,000 250,000
Special project 390,000 150,000
Quality reporting 260,000 240,000
Proofreading 800,000 860,000
Other inspection 460,000 580,000
Correction of typos 350,000 200,000
Plate revisions 100,000 380,000
Press downtime 200,000 260,000
Waste 70,000 120,000
Returns/allowances 400,000 620,000
Lost sales 200,000 330,000
Rework 120,000 310,000

Required:
1. Prepare an interim quality cost performance report for 20X5 that compares actual quality
costs with budgeted quality costs. Comment on the firm’s ability to achieve its quality
goals for the year.
2. Prepare a single-period quality performance report for 20X5 that compares the actual
quality costs of 20X4 with the actual costs of 20X5. How much did profits change
because of improved quality?
3. Prepare a graph that shows the trend in total quality costs as a percentage of sales since the
inception of the quality improvement program.
4. Prepare a graph that shows the trend for all four quality cost categories for 20X1 through
20X5. How does this graph help management know that the reduction in total quality
costs is attributable to quality improvements?
5. Assume that the company is preparing a second 5-year plan to reduce quality costs to 2.5%
of sales. Prepare a long-range quality cost performance report that compares the costs for
20X5 with those planned for the end of the second 5-year period. Assume sales of $45
million at the end of 5 years. The final planned relative distribution of quality costs is as
follows: proofreading, 50%; other inspection, 13%; quality training, 30%; and quality
reporting, 7%. Assume that all prevention costs are fixed and all other costs are variable
(with respect to sales).

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786 Chapter 13 Emerging Topics in Managerial Accounting

O BJE C T I V E 3 ▶
Case 13-64 Ethical Considerations
Lindell Manufacturing embarked on an ambitious quality program that is centered on contin-
ual improvement. This improvement is operationalized by declining quality costs from year to
year. Lindell rewards plant managers, production supervisors, and workers with bonuses rang-
ing from $1,000 to $10,000 if their factory meets its annual quality cost goals.
Len Smith, manager of Lindell’s Boise plant, felt obligated to do everything he could to
provide this increase to his employees. Accordingly, he has decided to take the following actions
during the last quarter of the year to meet the plant’s budgeted quality cost targets:
a. Decrease inspections of the process and final product by 50% and transfer inspectors
temporarily to quality training programs. Len believes this move will increase the
inspectors’ awareness of the importance of quality; also, decreasing inspection will
produce significantly less downtime and less rework. By increasing the output and
decreasing the costs of internal failure, the plant can meet the budgeted reductions for
internal failure costs. Also, by showing an increase in the costs of quality training, the
budgeted level for prevention costs can be met.
b. Delay replacing and repairing defective products until the beginning of the following
year. While this may increase customer dissatisfaction somewhat, Len believes that most
customers expect some inconvenience. Besides, the policy of promptly dealing with
customers who are dissatisfied could be reinstated in 3 months. In the meantime, the
action would significantly reduce the costs of external failure, allowing the plant to meet
its budgeted target.
c. Cancel scheduled worker visits to customers’ plants. This program, which has been very
well received by customers, enables Lindell workers to see just how the machinery they
make is used by the customer and also gives them first-hand information on any remaining
problems with the machinery. Workers who went on previous customer site visits came
back enthusiastic and committed to Lindell’s quality program. Lindell’s quality program
staff believes that these visits will reduce defects during the following year.

Required:
1. Evaluate Len’s ethical behavior. In this evaluation, consider his concern for his employees.
Was he justified in taking the actions described? If not, what should he have done?
2. Assume that the company views Len’s behavior as undesirable. What can the company do
to discourage it?
3. Assume that Len is a CMA and a member of the IMA. Refer to the ethical code for
management accountants in Chapter 1. Were any of these ethical standards violated?

O BJE C T I V E 5 ▶
Case 13-65 Transfer Pricing and Ethical Issues
Paterson Company,* a U.S.-based company, manufactures and sells electronic components
worldwide. Virtually all its manufacturing takes place in the United States. The company has
marketing divisions throughout Europe, including France. Debbie Kishimoto, manager of this
division, was hired from a competitor 3 years ago. Debbie, recently informed of a price increase
in one of the major product lines, requested a meeting with Jeff Phillips, marketing vice presi-
dent. Their conversation follows.
Debbie: “Jeff, I simply don’t understand why the price of our main product has increased from
$5.00 to $5.50 per unit. We negotiated an agreement earlier in the year with our manufactur-
ing division in Philadelphia for a price of $5.00 for the entire year. I called the manager of that
division. He said that the original price was still acceptable—that the increase was a directive
from headquarters. That’s why I wanted to meet with you. I need some explanations. When I
was hired, I was told that pricing decisions were made by the divisions. This directive interferes
with this decentralized philosophy and will lower my division’s profits. Given current market

*This scenario is based on the experiences of an actual firm. Names have been changed to preserve confidentiality.

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
 Chapter 13 Emerging Topics in Managerial Accounting 787

conditions, there is no way we can pass on the cost increase. Profits for my division will drop at
least $600,000 if this price is maintained. I think a midyear increase of this magnitude is unfair
to my division.”
Jeff: “Under normal operating conditions, headquarters would not interfere with divisional de-
cisions. But as a company, we are having some problems. What you just told me is exactly why
the price of your product has been increased. We want the profits of all our European marketing
divisions to drop.”
Debbie: “What do you mean that you want the profits to drop? That doesn’t make any sense.
Aren’t we in business to make money?”
Jeff: “Debbie, what you lack is corporate perspective. We are in business to make money, and
that’s why we want European profits to decrease. Our U.S. divisions are not doing well this
year. Projections show significant losses. At the same time, projections for European opera-
tions show good profitability. By increasing the cost of key products transferred to Europe—
to your division, for example—we increase revenues and profits in the United States. By
decreasing your profits, we avoid paying taxes in France. With losses on other U.S. operations
to offset the corresponding increase in domestic profits, we avoid paying taxes in the United
States as well. The net effect is a much-needed increase in our cash flow. Besides, you know
how hard it is in some of these European countries to transfer out capital. This is a clean way
of doing it.”
Debbie: “I’m not so sure that it’s clean. I can’t imagine the tax laws permitting this type of
scheme. There is another problem, too. You know that the company’s bonus plans are tied to a
division’s profits. This plan could cost all of the European managers a lot of money.”
Jeff: “Debbie, you have no reason to worry about the effect on your bonus—or on our evalua-
tion of your performance. Corporate management has already taken steps to ensure no loss of
compensation. The plan is to compute what income would have been if the old price had pre-
vailed and base bonuses on that figure. I’ll meet with the other divisional managers and explain
the situation to them as well.”
Debbie: “The bonus adjustment seems fair, although I wonder if the reasons for the drop in
profits will be remembered in a couple of years when I’m being considered for promotion.
Anyway, I still have some strong ethical concerns about this. How does this scheme relate to the
tax laws?”
Jeff: “We will be in technical compliance with the tax laws. In the United States, Section 482
of the Internal Revenue Code governs this type of transaction. The key to this law, as well as
most European laws, is evidence of an arm’s-length price. Since you’re a distributor, we can use
the resale price method to determine such a price. Essentially, the arm’s-length price for the
transferred good is backed into by starting with the price at which you sell the product and
then adjusting that price for the markup and other legitimate differences, such as tariffs and
transportation.”
Debbie: “If I were a French tax auditor, I would wonder why the markup dropped from last year
to this year. Are we being good citizens and meeting the fiscal responsibilities imposed on us by
each country in which we operate?”
Jeff: “Well, a French tax auditor might wonder about the drop in markup. But, the markup is
still within reason, and we can make a good argument for increased costs. In fact, we’ve already
instructed the managers of our manufacturing divisions to legitimately reassign as many costs as
they can to the European product lines. So far, they have been very successful. I think our records
will support the increase that you are receiving. You really do not need to be concerned with the
tax authorities. Our tax department assures me that this has been carefully researched—it’s un-
likely that a tax audit will create any difficulties. It’ll all be legal and above board. We’ve done this
several times in the past with total success.”

(Continued)

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788 Chapter 13 Emerging Topics in Managerial Accounting

Required:
1. Do you think that the tax-minimization scheme described to Debbie Kishimoto is in
harmony with the ethical behavior that should be displayed by top corporate executives?
Why or why not? What would you do if you were Debbie?
2. Apparently, the tax department of Paterson Company has been strongly involved in
developing the tax-minimization scheme. Assume that the accountants responsible for
the decision are CMAs and members of the IMA, subject to the IMA standards of ethical
conduct. Review the IMA standards for ethical conduct in Chapter 1. Are any of these
standards being violated by the accountants in Paterson’s tax department? If so, identify
them. What should these tax accountants do if requested to develop a questionable tax-
minimization scheme?

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203