ACCOUNTING REPLY

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Please review the question and answer. Respond to the answer in no less than 250 words.

Question:

In 2012 the Moncrief Company purchased from Jim Lester the right to be the sole distributor in the western states of a product called Zelenex. In payment, Moncrief agreed to pay Lester 20% of the gross profit recognized from the sale of Zelenex in 2013.

Moncrief uses a periodic inventory system and the LIFO inventory method. Late in 2013, the following information is available concerning the inventory of Zelenex:

Beginning Inventory 1/1/13 (10,000 Units @ $30)…………$300,000

Purchases (40,000 Units @ $30)……………………………1,200,000

Sales (35,000 Units @ $60)…………………………………$2,100,000

By the end of the year, the purchase price of Zelenex had risen to $40 per unit. On December 28, 2013, three days before year-end, Moncrief is in a position to purchase 20,000 additional units of Zelenex at the $40 per unit price. Due to the increase in purchase price, Moncrief will increase the selling price in 2014 to $80 per unit. Inventory on hand before the purchase, 15,000 units, is sufficient to meet the next six months’ sales and the company does not anticipate any significant changes in purchase price during 2014.

Required:

Answer:

Ethics Case 8-7: Profit Manipulation and Cost Flow Methods

Requirement 1

The agreement between the Moncrief company and Jim Lester requires Moncrief to pay Jim Lester 20% of gross profit from the sale of Zelenex in 2013 (Spiceland, Sepe, and Nelson, 2013, p. 469). If Moncrief were to purchase an additional 20,000 units on December 28, 2013, there would be a noticeable effect on the payment due to Jim Lester. Due to Moncrief’s utilization of the periodic LIFO (Last In First Out) inventory method, all of the 35,000 units sold in 2013 would be accounted for at the new $40 purchase price rather than the original $30 for which they were purchased. Moncrief does not plan to change the sale price of Zelenex until 2014, therefore, the gross profit would be calculated using the original $60 sale price of the units sold. The gross profit before purchasing the units at $40 would be 50% ($30 profit / $60 net sales). With the new purchase price, the gross profit would fall to 33% ($20 profit / $60 net sales). Moncrief sold 35,000 units in 2013, therefore the gross profit before the additional purchase would be $1,050,000 (35000 * $30), which would require a payment of $210,000 (20% of gross profit) to Jim Lester. While accounting for the additional purchase, the gross profit would be only $700,000 (35000 * $20) making the payment to Jim Lester only $140,000.

Requirement 2

              The difference in gross profit creates an ethical dilemma for Moncrief because this simple purchase of additional units creates a $70,000 variance in the payment to Jim Lester. While this purchase makes sense for the business bottom line, it is unethical to withhold $70,000 from Jim Lester. Lester sold the rights for Moncrief to be the western sole distributor of Zelenex and gave Moncrief the opportunity to create such a profit in the first place. Moncrief has enough units of Zelenex in their current inventory to last the first six months of 2014. The purchase of additional units at the end of 2013 would solely be a move to show a smaller gross profit and therefore pay less to Lester and less income tax.

Conclusion

              “A taxpayer is not permitted to use a method of accounting that does not clearly reflect income.” (Zarzar, Turgeon, and Rabinowitz, 2007, p. 37). If Moncrief were to make this purchase at year’s end while using the periodic LIFO inventory method, their income would not be accurately reflected. All 35,000 units sold in 2013 were purchased at $30, therefore, to show $40 in the gross profit calculation would be dishonest and unethical. “Moreover, they did not require an accounting from the men into whose hand they gave the money to pay to those who did the work, for they dealt faithfully” (2 Kings 12:15, New American Standard Bible). Jim Lester sold the distributorship rights to Moncrief in good faith as mentioned in 2 Kings. While this may seem to be an insignificant transaction, it would betray that good faith transaction with Lester. If Moncrief’s only concern is the almighty dollar, this transaction makes sense, but is simply unethical.

References

Spiceland, J.D., Sepe, J.F., & Nelson, M.W. (2013). Intermediate Accounting (7^th ed.).

New York, NY: McGraw-Hill/Irwin.

Zarzar, B., Turgeon, C., & Rabinowitz, S. (2007, April/May). The LIFO Inventory Method as it

Stands Today. Retail Merchandiser. 47(4). 27.