CHAPTER 22 DISCUSSION QUESTIONS Q22-1 Effective planning and control of capital expenditures are important because: (a) financial risk is increased by long-term commitments; (b) the magnitude of capital expenditures is substantial and the penalties for unwise decisions are usually severe; (c) decisions made in this area provide the supporting structure for operating activities of the firm Q22-2 Examples of opportunities and temptations for unethical behavior in the capital budgeting area include: (a) pressure applied to the cost/managerial accountant by superiors or associates to circumvent the capital expenditure approval process, in order to get a pet project approved; (b) pressure to write off or devalue assets below their true value in order to justify replacement; (c) exaggerating the expected economic benefits of a pet project in order to increase the likelihood of getting it approved Q22-3 The cost/managerial accountant has an obligation to the company to make sure that the company’s legitimate policies and procedures are not circumvented and to make sure that the data used in the evaluation of capital expenditure proposals are as reliable and realistic as possible If an ethical violation occurs, the cost/managerial accountant should first discuss the perceived problem with his or her immediate supervisor (in order to clarify the significance of the problem and identify possible courses of action) and then with the individual or individuals involved If the individual involved is the accountant’s immediate supervisor, the cost/managerial accountant should consult the next higher level of management If the problem cannot be resolved through discussion, the cost/managerial accountant is obligated to provide a full disclosure of all the details to the executives responsible for evaluating and approving capital expenditures Q22-4 The economic life of a project is the period during which it produces earnings It need not, and probably will not, be equal to the physical life of the related asset(s) Its length depends primarily upon the obsolescence of the product or manufacturing process involved or the nature of the product itself Managers usually find it quite difficult to estimate economic life because it depends upon future events over which they may have little or no control Q22-5 Cash outflows that might be expected for a capital expenditure include: (a) purchase price of one or more assets (or a down payment if property is purchased on installment); (b) construction period interest and taxes if the property is being constructed; (c) machinery and equipment setup cost, particularly if machinery being evaluated utilizes a more advanced technology than that currently in use; (d) computer software development cost if a computer aided design, computer aided manufacturing, or fully computer integrated manufacturing system is being purchased; (e) increased annual maintenance and/or power costs resulting from more complicated or technologically advanced machinery or equipment; (f) lease payments, if some or all of the assets being acquired in the project are leased; (g) working capital requirements (inventory, cash on hand, receivables, payables, etc.) may increase as a result of increased business generated by the capital project Q22-6 Cash inflows that might be expected from a capital expenditure include: (a) revenues from additional business generated by the project; (b) cost savings created by the capital expenditure that result in a reduction of cash outflows (e.g., maintenance savings, 22-1 22-2 labor savings, reduced inventory requirements resulting from reduced setup times, etc.); (c) retention of market share that might have been lost if the capital expenditure were not made (particularly in the case of advanced technologies that improve product quality, reduce costs, provide manufacturing flexibility, etc that can provide a competitive advantage to the firm with the technology); (d) salvage from the sale of the property at the end of the economic life of the capital project Q22-7 Some nonquantifiable benefits from investing in advanced manufacturing technologies, such as CIM, FMS, and robotics, include: (a) improved product quality (ability to meet closer production tolerances and at the same time reduce the variability in production output); (b) decreased machine setup and shorter manufacturing cycle times (which provide the company with the ability to adjust output quantity and variety quickly to meet rapidly changing customer demands) Q22-8 Tax depreciation is quite likely to differ from book depreciation because the cost recovery period used for tax purposes is usually shorter than the economic life of the asset used for financial accounting purposes Also, an accelerated method of depreciation is typically used for tax purposes, whereas the straight-line method is more often used for book purposes Q22-9 Book depreciation should not be considered in estimating the future cash flows from a project because book depreciation has no effect on the amount or timing of cash flows Q22-10 Tax depreciation should be considered in estimating the future cash flows from a project because tax depreciation reduces taxable income and, therefore, tax liability Tax depreciation results in a tax savings, i.e., a reduction Chapter 22 of tax liability that is a cash outflow The timing of cash flows is affected by the tax depreciation method and the recovery period used Q22-11 Financial accounting data are not entirely suitable for use in evaluating capital expenditure proposals because: (a) Financial accounting uses the accrual basis Capital expenditure decisions generally rely on estimates of cash flows, rather than revenues and expenses determined on the accrual basis (b) Financial accounting is designed to measure periodic earnings Capital expenditure evaluation is concerned with the life of a given project, which seldom corresponds to usual accounting periods (c) Financial accounting measures the results of operations of a company or a segment of a company Although this entity sometimes corresponds with a capital expenditure project, it is usually composed of many intermingled capital expenditure projects (d) Financial accounting capitalizes expenditures if the expenditure is deemed to have a future value or benefit to the company Capitalization is an attempt to match expenditures with revenues generated by those expenditures When future value or benefit cannot be reliably measured, financial accounting treats the expenditure as a period expense rather than as an asset acquisition Q22-12 Benefits of following up project results include: (a) comparison of actual with projected results to ensure that a project is meeting expected performance, or taking corrective action or terminating a project that is not achieving expected performance; (b) evaluation of accuracy of projections from different departments; (c) improvement of future capital estimates; (d) motivation of personnel arising from knowledge that follow-up will occur Chapter 22 22-3 EXERCISES E22-1 Estimated Unit Unit Unit Demand Sales Variable Contribution Year in Units Price Cost Margin 12,000 $25 $15 $10 12,000 25 15 10 12,000 25 15 10 12,000 25 15 10 12,000 25 15 10 Total net pretax cash inflows from sales Initial cash outflow (cost of asset) $500,000 Less pretax estimated salvage value (100,000) Excess of net pretax cash inflows over cost Net Pretax Cash Inflows From Sales $120,000 120,000 120,000 120,000 120,000 $600,000 400,000 $200,000 E22-2 Estimated Unit Unit Unit Demand Sales Variable Contribution Year in Units Price Cost Margin 6,000 $12 $9 $3 8,000 12 3 10,000 12 10,000 12 10,000 12 10,000 12 10,000 12 8,000 12 9 6,000 12 10 4,000 12 Total net pretax cash inflows from sales Initial cash outflow (cost of machine) $150,000 Less pretax estimated salvage value (20,000) Excess of net pretax cash inflows over cost Net Pretax Cash Inflows From Sales $ 18,000 24,000 30,000 30,000 30,000 30,000 30,000 24,000 18,000 12,000 $246,000 130,000 $116,000 22-4 Chapter 22 E22-3 Estimated 6% Annual Net Pretax Price-level Year Cash Inflows Adjustment $15,000 (1 + 06)1 = 1.060 20,000 (1 + 06)2 = 1.124 20,000 (1 + 06)3 = 1.191 20,000 (1 + 06)4 = 1.262 15,000 (1 + 06)5 = 1.338 10,000 (1 + 06)6 = 1.419 Total price-level adjusted net pretax cash inflows from operations Plus cash inflow from salvage $5,000 Price-level adjustment 1,419 Total price-level adjusted net pretax cash inflows Less initial cash outflow Excess of net pretax cash inflows over initial cash outflow Price-level Adjusted Net Cash Inflows $15,900 22,480 23,820 25,240 20,070 14,190 Estimated 9% Annual Net Pretax Price-level Year Cash Inflows Adjustment $20,000 (1 + 09)1 = 1.090 30,000 (1 + 09)2 = 1.188 40,000 (1 + 09)3 = 1.295 60,000 (1 + 09)4 = 1.412 60,000 (1 + 09)5 = 1.539 60,000 (1 + 09)6 = 1.677 60,000 (1 + 09)7 = 1.828 60,000 (1 + 09)8 = 1.993 40,000 (1 + 09)9 = 2.172 10 20,000 (1 + 09)10 = 2.367 Total price-level adjusted net pretax cash inflows from operations Plus cash inflow from salvage $10,000 Price-level adjustment 2.357 Total price-level adjusted net pretax cash inflows Less initial cash outflow Excess of net pretax cash inflows over initial cash outflow Price-level Adjusted Net Cash Inflows $ 21,800 35,640 51,800 84,720 92,340 100,620 109,680 119,580 86,880 47,340 $121,700 7,095 $128,795 75,000 $53,795 E22-4 $750,400 23,670 $774,070 250,000 $524,070 ** Year MACRS 5-year Recovery Rate 200 320 192 115 115 058 1.000 Depreciable Basis $600,000 600,000 600,000 600,000 600,000 600,000 *Annual hours of operating capacity Savings per hour with CIM Tax Depreciation $120,000 192,000 115,200 69,000 69,000 34,800 $600,000 20,000 × $20 $400,000 (1) (2) (3) (4) (5) Annual Additional Tax Liability Operating Maintenance Tax Taxable With 40% Savings Cost DepreIncome Tax Rate Year With CIM* With CIM ciation** (1) – (2) – (3) 40% × (4) $400,000 $200,000 $120,000 $ 80,000 $32,000 400,000 200,000 192,000 8,000 3,200 400,000 200,000 115,200 84,800 33,920 400,000 200,000 69,000 131,000 52,400 400,000 200,000 69,000 131,000 52,400 400,000 200,000 34,800 165,200 66,080 Total net after-tax cash inflows Less initial cash outflow to purchase system Excess of net after-tax cash inflows over initial cash outflow E22-5 (6) Net After-tax Cash Inflows (1) – (2) – (5) $168,000 196,800 166,080 147,600 147,600 133,920 $960,000 600,000 $360,000 Chapter 22 22-5 22-6 Chapter 22 E22-6 (1) (2) (3) (4) Estimated Taxable Tax Liability InflationTax Income With 40% Adjusted Net Depre(Loss) Tax Rate Year Cash Inflows ciation* (1) – (2) 40% × (3) $30,000 $40,000 $(10,000) $(4,000) 40,000 64,000 (24,000) (9,600) 50,000 38,400 11,600 4,640 60,000 23,000 37,000 14,800 70,000 23,000 47,000 18,800 80,000 11,600 68,400 27,360 60,000 60,000 24,000 Total net after-tax cash inflows Less initial cash outflow to purchase system Excess of net after-tax cash inflows over initial cash outflow * Year MACRS 5-year Recovery Rate 200 320 192 115 115 058 1.000 Depreciable Basis $200,000 200,000 200,000 200,000 200,000 200,000 (5) Net After-tax Cash Inflows (1) – (4) $ 34,000 49,600 45,360 45,200 51,200 52,640 36,000 $314,000 200,000 $114,000 Tax Depreciation $ 40,000 64,000 38,400 23,000 23,000 11,600 $200,000 Chapter 22 22-7 E22-7 (1) (2) (3) (4) (5) Estimated Taxable Tax Liability Net Periodic Tax Income With 40% After-tax Net Cash Depre(Loss) Tax Rate Cash Inflows Year Inflows ciation* (1) – (2) 40% × (3) (1) – (4) $10,000 $14,300 $(4,300) $(1,720) $ 11,720 15,000 24,500 (9,500) (3,800) 18,800 20,000 17,500 2,500 1,000 19,000 25,000 12,500 12,500 5,000 20,000 25,000 8,900 16,100 6,440 18,560 25,000 8,900 16,100 6,440 18,560 25,000 8,900 16,100 6,440 18,560 20,000 4,500 15,500 6,200 13,800 15,000 15,000 6,000 9,000 10 10,000 10,000 4,000 6,000 Total net after-tax cash inflows $154,000 After-tax cash inflow from salvage at end of economic life: Pretax cash inflow from salvage $10,000 Less tax payable on sale at 40% tax rate 4,000 6,000 Total net after-tax cash inflows $160,000 Less initial cash outflow to purchase system 100,000 Excess of net after-tax cash inflows over initial cash outflow $ 60,000 * Year MACRS 7-year Recovery Rate 143 245 175 125 089 089 089 045 1.000 Depreciable Basis $100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 Tax Depreciation $ 14,300 24,500 17,500 12,500 8,900 8,900 8,900 4,500 $100,000 22-8 Chapter 22 Problems P22-1 (1) Year Year Periodic Cash Inflows $19,000 22,000 24,000 18,000 15,000 10,000 $109,000 (1) Depreciable Basis of Property $60,000 60,000 60,000 60,000 60,000 60,000 (2) 8% Price-Level Adjustment (1 + 08) = 1.080 (1 + 08)2 = 1.166 (1 + 08)3 = 1.260 (1 + 08)4 = 1.360 (1 + 08)5 = 1.469 (1 + 08)6 = 1.587 (2) 5-Year Property Recovery Percentage 200 320 192 115 115 058 (3) InflationAdjusted Estimated Cash Inflows (1) × (2) $ 20,520 25,652 30,240 24,480 22,035 15,870 $138,797 (3) Tax Depreciation (1) × (2) $12,000 19,200 11,520 6,900 6,900 3,480 $60,000 (1) (2) (3) (4) (5) Federal Adjusted Taxable and Estimate of Tax Income State Income Net Cash Depre(Loss) Income Tax Year Inflows ciation (1) – (2) Tax Rate (3) × (4) $20,520 $12,000 $ 8,520 40% $3,408 25,652 19,200 6,452 40% 2,581 30,240 11,520 18,720 40% 7,488 24,480 6,900 17,580 40% 7,032 22,035 6,900 15,135 40% 6,064 15,870 3,480 12,390 40% 4,956 Total estimated net after-tax cash inflows from project Less initial cash outlay for machinery Excess of after-tax cash inflows from project over Initial cash outflow P22-1 (Concluded) (6) Net After-tax Cash Inflows (1) – (5) $ 17,112 23,071 22,752 17,448 15,981 10,914 $107,278 60,000 $ 47,278 Chapter 22 22-9 22-10 Chapter 22 P22-2 Cost of new machine Trade-in allowance for old machine Net cash outflow at beginning of project Tax basis of old machine traded in Tax basis of new machine $18,000 9,000 $ 9,000 8,000 $17,000 Annual cost of operating old machine Annual cost of operating new machine Annual cost savings with new machine $20,000 16,400 $ 3,600 Year Year (1) (2) Original Tax Basis of Old Machine $10,000 10,000 10,000 10,000 10,000 5-Year Property Recovery Rate 320 192 115 115 058 (1) (2) Original Tax Basis of New Machine $17,000 17,000 17,000 17,000 17,000 17,000 5-Year Property Recovery Rate 200 320 192 115 115 058 (3) Tax Depreciation on Old Machine (1) × (2) $3,200 1,920 1,150 1,150 580 $8,000 (3) Tax Depreciation on New Machine (1) × (2) $3,400 5,440 3,264 1,955 1,955 986 $17,000 Note that year is actually the second year the old property is depreciated Therefore, the recovery rate for the second year is used to compute the amount of depreciation on the old property in the first year of the capital expenditure proposal (1) (2) (3) (4) Contribution Unit Unit Margin Estimated Sales Variable Per Unit Year Demand Price Cost (2) – (3) 1,000 $11 $5 $6 1,000 11 1,000 11 1,000 11 1,000 11 6 1,000 11 1,000 11 Total periodic cash inflows (1) P22-5 (5) Net Cash Inflow From Sales (1) × (4) $ 6,000 6,000 6,000 6,000 6,000 6,000 6,000 $42,000 (6) Cost Savings From Reduced Maintenance $1,500 1,200 900 600 300 0 $4,500 Periodic Net Cash Inflows (5) + (6) $ 7,500 7,200 6,900 6,600 6,300 6,000 6,000 $46,500 (7) 22-16 Chapter 22 Chapter 22 22-17 P22-5 (Continued) Year Recovery Year (1) (2) Periodic Net Cash Inflows $ 7,500 7,200 6,900 6,600 6,300 6,000 6,000 $46,500 Annual 10% Price-Level Adjustment (1 + 10) = 1.100 (1 + 10)2 = 1.210 (1 + 10)3 = 1.331 (1 + 10)4 = 1.464 (1 + 10)5 = 1.611 (1 + 10)6 = 1.772 (1 + 10)7 = 1.949 (1) Depreciable Basis of Machine $40,000 40,000 40,000 40,000 40,000 40,000 (2) 5-Year Property Recovery Percentage 200 320 192 115 115 058 (3) Tax Depreciation (1) × (2) $ 8,000 12,800 7,680 4,600 4,600 2,320 $40,000 (3) Adjusted Estimate of Net Cash Inflows (1) × (2) $ 8,250 8,712 9,184 9,662 10,149 10,632 11,694 $68,283 (1) (2) (3) 7,016 $63,984 (6) Net After-tax Cash Inflows (1) – (5) $ 8,150 10,347 8,582 7,637 7,929 7,307 7,016 $56,968 (2) Total after-tax cash inflows from the capital expenditure Less original investment cash outflow Excess of total after-tax cash inflows over initial investment $63,984 40,000 $23,984 **The cash inflow from the salvage sale at the end of the project would be fully taxable because the tax basis of the machine would be zero (i.e., the machine was fully depreciated) Thus, the tax on the cash inflow from salvage would be $4,678 ($11,694 × 40%) *$6,000 estimated salvage value × 1.949 inflation adjustment (10% for years) (4) (5) Federal Income Adjusted Taxable and Tax Estimate of Income State Payment Net Cash Tax (Loss) Income (Reduction) Year Inflows Depreciation (1) – (2) Tax Rate (3) × (4) $ 8,250 $ 8,000 $ 250 40% $ 100 8,712 12,800 (4,088) 40% (1,635) 9,184 7,680 1,504 40% 602 9,662 4,600 5,062 40% 2,025 10,149 4,600 5,549 40% 2,220 10,632 2,320 8,312 40% 3,325 11,694 11,694 40% 4,678 Total after-tax cash inflow from sales and cost savings After-tax cash inflow from salvage at end of economic life: Cash inflow from salvage (adjusted for expected 10% inflation)* $11,694 Tax payable on salvage sale** 4,678 Total net after-tax cash inflows from the capital expenditure P22-5 (Concluded) 22-18 Chapter 22 Chapter 22 22-19 P22-6 Year 10 Year (1) (2) Unadjusted Cash Inflows $15,000 20,000 25,000 25,000 25,000 25,000 25,000 20,000 15,000 10,000 Annual 10% Price-Level Adjustment (1 + 10) = 1.100 (1 + 10)2 = 1.210 (1 + 10)3 = 1.331 (1 + 10)4 = 1.464 (1 + 10)5 = 1.611 (1 + 10)6 = 1.772 (1 + 10)7 = 1.949 (1 + 10)8 = 2.144 (1 + 10)9 = 2.358 (1 + 10)10 = 2.594 (1) Tax Basis of Depreciable Property $100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 (2) 7-Year Property Recovery Rate 143 245 175 125 089 089 089 045 (3) Tax Depreciation Available (1) × (2) $ 14,300 24,500 17,500 12,500 8,900 8,900 8,900 4,500 $100,000 (3) InflationAdjusted Cash Inflows (1) × (2) $16,500 24,200 33,275 36,600 40,275 44,300 48,725 42,880 35,370 25,940 (1) (2) (3) (4) (5) InflationIncrease Increase Adjusted (Decrease) (Decrease) Annual Tax in Taxable Income in Income Cash Depreciation Income Tax Taxes Year Inflows Available (1) – (2) Rate (3) × (4) $16,500 $14,300 $ 2,200 40% $ 880 24,200 24,500 (300) 40% (120) 33,275 17,500 15,775 40% 6,310 36,600 12,500 24,100 40% 9,640 40,275 8,900 31,375 40% 12,550 44,300 8,900 35,400 40% 14,160 48,725 8,900 39,825 40% 15,930 42,880 4,500 38,380 40% 15,352 35,370 35,370 40% 14,148 10 25,940 25,940 40% 10,376 Total periodic after-tax cash inflows After-tax cash inflow from salvage: Inflation-adjusted cash inflow from salvage ($2,000 × 2.594) $5,188 Tax payable on salvage ($5,188 × 40%) 2,075 Total after-tax cash inflows from project Less initial investment cash outflow Excess of total after-tax cash inflows over initial investment P22-6 (Concluded) 3,113 $251,952 100,000 $151,952 After-tax Cash Inflows (1) – (5) $ 15,620 24,320 26,965 26,960 27,725 30,140 32,795 27,528 21,222 15,564 $248,839 (6) 22-20 Chapter 22 Savings from Reduced Labor $15,000 25,000 35,000 35,000 35,000 35,000 Year (1) $25,000 30,000 35,000 35,000 35,000 35,000 (2) Savings from Reduced Machine Setup Time $20,000 25,000 30,000 30,000 30,000 30,000 Savings from Reduced Inventory (3) $ 60,000 80,000 100,000 100,000 100,000 100,000 (4) Total Periodic Savings from CIM (1) + (2) + (3) $10,000 10,000 10,000 10,000 10,000 10,000 (5) Additional Maintenance Cost with CIM $50,000 70,000 90,000 90,000 90,000 90,000 (6) Net Periodic Savings with CIM (4) – (5) (1 + 06) (1 + 06)2 (1 + 06)3 (1 + 06)4 (1 + 06)5 (1 + 06)6 = = = = = = (6) $53,000 78,680 107,190 113,580 120,420 127,710 (8) InflationAdjusted Periodic Savings (6) × (7) 1,200,000 $(359,652) Periodic Net After-tax Cash Inflows (1) – (5) $ 127,800 191,208 157,114 130,148 134,252 99,826 $ 840,348 1.060 1.124 1.191 1.262 1.338 1.419 Annual 6% Inflation Adjustment (7) (1) (2) (3) (4) (5) InflationAdjusted Tax Taxable Tax Periodic Depreciation Income Effective Liability Savings and (Loss) Tax (Refund) Year with CIM Amortization* (1) – (2) Rate (3) × (4) $ 53,000 $240,000 $(187,000) 40% $ (74,800) 78,680 360,000 (281,320) 40% (112,528) 107,190 232,000 (124,810) 40% (49,924) 113,580 155,000 (41,420) 40% (16,568) 120,420 155,000 (34,580) 40% (13,832) 127,710 58,000 69,710 40% 27,884 Total annual after-tax savings from investment in CIM Less initial investment: Equipment cost $1,000,000 Software cost 200,000 Excess of cost of CIM system over after-tax savings (1) P22-7 Chapter 22 22-21 Year (2) Rate for MACRS 5-year Property 200 320 192 115 115 058 (1) Recovery Property Tax Basis $1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Tax Depreciation (1) × (2) $ 200,000 320,000 192,000 115,000 115,000 58,000 $1,000,000 (3) Software Tax Basis $200,000 200,000 200,000 200,000 200,000 200,000 (4) 5-year Straight-line Amortization Rate 200 200 200 200 200 000 (5) Tax Amortization (4) × (5) $ 40,000 40,000 40,000 40,000 40,000 $200,000 (6)) (7) Total Tax Amortization and Depreciation (3) + (6) $ 240,000 360,000 232,000 155,000 155,000 58,000 $1,200,000 (1) (2) (3) (4) (5) (6) (7) (8) InflationInflationTax Periodic Adjusted Adjusted Net DepreNet Periodic Lost Periodic Periodic ciation Taxable Tax After-tax Savings Contribution Savings and Income Effective Liability Cash with CIM Margin Saved with CIM Amor(Loss) Tax (Refund) Inflows Year from Part (1) with CIM** (1) + (2) tization* (3) – (4) Rate (5) × (6) (3) – (7) $ 53,000 $212,000 $265,000 $240,000 $ 25,000 40% $ 10,000 $ 255,000 78,680 224,800 303,480 360,000 (56,520) 40% (22,608) 326,088 107,190 238,200 345,390 232,000 113,390 40% 45,356 300,034 113,580 252,400 365,980 155,000 210,980 40% 84,392 281,588 120,420 267,600 388,020 155,000 233,020 40% 93,208 294,812 127,710 283,800 411,510 58,000 353,510 40% 141,404 270,106 Total annual after-tax savings from investment in CIM $1,727,628 Less initial investment for equipment and software (from above) 1,200,000 Excess of after-tax savings over cost of CIM system with new information $ 527,628 (2) * P22-7 (Continued) 22-22 Chapter 22 Chapter 22 22-23 P22-7 (Concluded) ** Year (1) (2) Lost Periodic Contribution Margin Saved with CIM $200,000 200,000 200,000 200,000 200,000 200,000 Annual 6% Inflation Adjustment (1 + 06) = 1.060 (1 + 06)2 = 1.124 (1 + 06)3 = 1.191 (1 + 06)4 = 1.262 (1 + 06)5 = 1.338 (1 + 06)6 = 1.419 (3) InflationAdjusted Lost Periodic Contribution Margin Saved with CIM (1) × (2) $212,000 224,800 238,200 252,400 267,600 283,800 22-24 Chapter 22 CASES C22-1 Some of the factors that affect the decision of whether or not to delay the investment in new cleaning equipment are given below Each factor can have two sides (i.e., delay versus no delay) depending upon the circumstances involved (a) Unemployment, inflation rate, and business conditions in general Business outlook improving—do not delay Business outlook deteriorating—delay All of these factors affect the climate for business and should be considered (b) Difficulty associated with acquisition and installation of equipment and training of operators Great difficulty—do not delay Little difficulty—delay The greater the lead time involved, the sooner the equipment should be acquired so that it is ready when needed (c) Extent of operating efficiency improvements Great—do not delay Little—delay The greater the efficiency, the less it should be delayed because costs will be saved even though volume does not increase (d) Inflation rate in cost of equipment Cost of equipment not expected to increase drastically—delay Cost of equipment expected to increase drastically—do not delay Company wants to minimize its initial cost outlay (e) Dependability of present equipment and likelihood of breakdowns Dependability is good—delay Dependability is not good—do not delay Company could defer, or have to go ahead with investment due to condition of present equipment (f) Chance for technological advances in equipment Good—delay No chance—do not delay If there is a chance that technological advances will develop in the design of the equipment, the company might want to take advantage of the new design (g) Ability to obtain market advantage by providing better quality service at same or lower price Good—do not delay Poor/neutral—delay Better service means more customers or justifies higher rates Chapter 22 22-25 C22-1 (Concluded) (h) Competitors’ plans for obtaining similar equipment and achieving market advantage High probability—do not delay Low probability—delay Company wants to maintain competitive advantage or meet competition (i) Ability to predict timing and increased volume of demand from new or existing customers Good—better quality of decision; could defer switch longer Low—less reliable criteria for decision The better a company is able to predict new business, the more certain It can be of its decision and, possibly, the longer it can wait to make a change C22-2 Knight is probably correct in her assessment that the proposed capital investment framework grants too much freedom to the divisions Neoglobe’s long-run performance depends on its capital investments While divisions must have some responsibility for capital investments for the proposed organization structure to be effective, corporate management must maintain adequate control to direct the future course of the firm Under the proposed framework, division management controls a substantial portion of the capital budget, and in some years, few funds would be available for investment by corporate management The present proposal would reduce corporate management’s ability to diminish a product line, and it also would impair management’s ability to have adequate funds available for investment in new businesses Capital investment procedures should involve both division and corporate managements in such a way that division management still should be able to influence the future direction of the firm Such procedures might include classification of capital projects into groups, some of which could be approved by division management without corporate management study An alternative to the Neoglobe capital investment program might have the following features: (a) All proposed investment projects would be classified according to their nature—replacement, cost savings, expansion (b) Replacement and cost savings projects could be adopted by division management alone, without approval of corporate management, provided an individual project did not exceed a specified dollar limit and the total of such projects did not exceed another specified dollar limit The dollar limits would reflect the nature and size of each division’s operations (c) All expansion projects, or other projects that exceed the dollar limit, would be submitted to corporate management for evaluation and approval 22-26 Chapter 22 C22-3 The process of planning for and evaluating long-term commitments of resources is normally referred to as capital expenditure planning, evaluating, and control, or capital budgeting The capital budget is distinct in that it focuses on the longterm effect of resources committed Its primary objectives are to provide management with (1) a formal process to chart its future course, (2) a means of ranking and selecting among alternative resource commitments to maximize return on investment, and (3) a program for ongoing evaluation of extant resource commitments Any significant resource commitment is viewed as a project Hence, the capital budget is composed of projects, some of which are in process and some of which are proposed Each project affects significant periods of time in the ongoing life of a company A project often involves the evaluation of alternatives and the purchase of such assets as property, plant, and equipment It should also consider, however, any proposal or program that requires a significant resource commitment over an extended period, such as the development of new products, opening new markets, and the design and development of major computer programs Once resources have been committed to a particular project, the project requires ongoing evaluation; i.e., are the project’s objectives being met? If not, it needs to be evaluated in terms of whether the project should be retained as is, modified if possible, or abandoned McAngus can make significant use of capital expenditure planning, evaluating, and control At the division level, projects will need to be defined in terms of those elements of the plant, or operation of the division, over which the manager has control On the basis of the facts given, the division manager has authority to operate his or her plant essentially as if it were an independent company Hence, anything affecting operations, which has required or will require significant resource commitment over a significant period of time, should form an integral part of that division’s capital budget At the top management level, the president may view each division as a project, particularly for evaluation purposes The other described activities of top management (investigating and evaluating such things as new markets, etc.) are projects in the capital budgeting sense These and other new proposals may be defined, analyzed, and evaluated using a variety of available techniques C22-4 (1) Arnett’s revision of the first proposal described in the case can certainly be considered a violation of the Standards of Ethical Conduct Arnett discarded the reasonable projections and estimates after being questioned and pressured by Earle, and used figures that have only a remote chance of occurring By doing this, Arnett violated the standard of objectivity (which requires that the management accountant communicate information fairly and objectively and disclose fully relevant information that could reasonably be expected to influence an Chapter 22 (2) (3) (4) 22-27 intended user’s understanding of the report presented) By altering the analysis, Arnett also violated the standard of integrity (which requires that the management accountant (1) refrain from engaging in an activity that would prejudice his or her ability to carry out the required duties ethically, and (2) communicate unfavorable as well as favorable information, professional judgments, and opinions) Arnett also violated the standard of competence (which requires that the management accountant prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information) Based on the facts in the case, Earle was certainly in violation of the Standards of Ethical Conduct as a result of pressuring a subordinate to prepare a proposal with data that were false and misleading Earle has violated the standards of competence (failed to perform professional duties in accordance with technical standards; and failed to prepare complete and clear reports and reliable information), integrity (engaged in an activity that would prejudice his or her ability to carry out required duties ethically, actively or passively subverted the attainment of the organization’s legitimate and ethical objectives, failed to communicate unfavorable as well as favorable information and professional judgments or opinions, and supported activity that would discredit the profession), and objectivity (failed to communicate information fairly and objectively and did not disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the report presented) The elements of the projection and estimation process that are compromised because of a predetermined, misleading outcome include: (a) the quality of the base data, (b) the quality of the assumptions used, (c) the probability of the projection occurring, and (d) the credibility of the people submitting the projection The internal controls Fore Corporation could implement to prevent unethical behavior include: (a) approval of all formal capital expenditure proposals by the controller and/or the board of directors, (b) designating a non-accounting/finance manager to coordinate capital expenditure requests and/or segregating duties during the preparation and approval of capital expenditure requests, (c) requiring all capital expenditure proposals be reviewed by senior operating management, which includes the controller, before the proposals are submitted for approval, and (d) requiring the internal audit staff to review all capital expenditure proposals or contracting with external auditors to review the proposal if the corporation does not have sufficient personnel 22-28 Chapter 22 C22-5 (1) Referring to the specific standards in the IMA’s Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management, the conduct of H Dodge and G Watson is unethical as discussed below: (a) H Dodge’s first revision of the proposal for the warehouse conversion was unethical because Dodge’s actions violate the following standards: Competence Although the estimates used in the analysis are based on management’s judgment, Dodge’s action in changing reasonable estimates to remote assumptions is unethical Management accountants have the responsibility to prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information Integrity Dodge has the responsibility to avoid conflicts of interest, refrain from subverting the attainment of the organization’s legitimate and ethical objectives (profitability), and refrain from engaging in or supporting any activity that would discredit the profession Objectivity Dodge has the responsibility to communicate information fairly and objectively and to disclose fully all relevant information that can influence an intended user’s understanding (b) G Watson’s conduct in giving H Dodge specific instructions on preparing the second revision of the proposal is unethical because Watson’s conduct violates the following specific standards: Competence Watson has the responsibility to perform his professional duties in accordance with relevant technical standards, such as using conservatism and realistic estimates in the net present value analysis Management accountants should prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information Confidentiality Watson should refrain from using or appearing to use confidential information acquired in the course of his work for unethical advantage for personal gain (saving on commuting time and costs) Integrity Watson has the responsibility to advise all parties of any potential conflict of interest Watson should refuse any favor (the warehouse reducing his commuting time) that would appear to influence his actions Watson should communicate unfavorable as well as favorable information and professional judgments and opinions Objectivity Watson has the responsibility to disclose fully all relevant information that can influence an intended user’s understanding of the analysis Chapter 22 22-29 C22-5 (Concluded) (2) Steps recommended by the Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management that H Dodge should follow in attempting to resolve this situation are as follows: (a) Dodge should first investigate and see if Evans Company has an established policy for resolving conflict, and if such a policy exists, Dodge should follow it (b) Since it appears that G Watson, Dodge’s superior, is involved, there is no need to confront Watson or discuss this issue with Watson any further Dodge should present the situation to the next higher level, the vice president of finance, for resolution (c) if Dodge does not receive any satisfaction, Dodge should continue to successively higher levels, including the audit committee and the board of directors, if necessary (d) Dodge should clarify the concepts of the issue at hand in a confidential discussion with an objective advisor, i.e., a peer (e) If the situation is still unresolved after exhausting all levels of internal review, Dodge will have no recourse but to resign and submit an informative memorandum to an appropriate representative of the organization (f) Unless legally bound (which does not appear to be the case in this situation), it is inappropriate to communicate this situation to authorities or individuals outside the organization (g) Dodge may consult with personal legal counsel C22-6 (1) By referring to the IMA’s Standards of Ethical Conduct and taking into consideration the specific standards of competence, confidentiality, integrity, and objectivity, L Forrest should evaluate B Rolland’s directives as follows: Competence Forrest has a responsibility to present complete and clear reports and recommendations after appropriate analysis of relevant and reliable information Rolland does not wish the report to be complete or clear, and has provided some information that is not totally reliable Confidentiality Forrest should not disclose confidential information outside of the organization; but it also appears that Rolland wants to refrain from disclosing information to the board of directors that it should know about Integrity Rolland is engaging in activities that could prejudice him from carrying out his duties ethically In evaluating Rolland’s directive as it affects Forrest, Forrest has an obligation to communicate unfavorable as well as favorable information and professional judgments or opinions 22-30 Chapter 22 Objectivity The responsibility to communicate information fairly and objectively, as well as to disclose fully all relevant information that could reasonably be expected to influence reports and recommendations presented, is being hampered The board of directors will not have the full scope of information they should have when they are presented with the analysis (2) By referring to the Standards of Ethical Conduct, L Forrest should take the following steps to resolve this situation: (a) Forrest should first investigate and see if IDI has an established policy for resolution of ethical conflicts and, if so, follow those procedures (b) If this policy does not resolve the ethical conflict, the next step would be for Forrest to discuss the situation with his supervisor, Rolland, and see if he can obtain resolution One possible solution may be to present a “base case” and sensitivity analysis of the investment Forrest should make it clear to Rolland that he has a problem and is seeking guidance (c) If Forrest cannot obtain a satisfactory resolution with Rolland, Forrest could take the situation up to the next layer of management, and inform Rolland that is being done If this is not satisfactory, Forrest should progress to the next level, and eventually to all higher levels of management until the issue is resolved (i.e., the president, audit committee, or board of directors) (d) Since Rolland has instructed him not to discuss the situation with anyone else at IDI, Forrest may want to have a confidential discussion with an objective advisor to clarify relevant concepts and obtain an understanding of possible courses of action Forrest may want to talk to a close professional friend or the IMA “Ethics Hotline” for this purpose (e) If Forrest cannot satisfactorily resolve the situation within the organization, he may resign from the company and submit an informative memo to an appropriate person in IDI (i.e., the president, audit committee, or board of directors) (f) Forrest may consult with personal legal counsel ... delayed because costs will be saved even though volume does not increase (d) Inflation rate in cost of equipment Cost of equipment not expected to increase drastically—delay Cost of equipment... investment in CIM Less initial investment: Equipment cost $1,000,000 Software cost 200,000 Excess of cost of CIM system over after-tax savings (1) P22-7... $18,000 9,000 $ 9,000 8,000 $17,000 Annual cost of operating old machine Annual cost of operating new machine Annual cost savings with new machine $20,000 16,400