ETHICAL ISSUES RELATED TO CONVERSION PROCESSES (STUDY OBJECTIVE 6)
Previous chapters examined ethical misconduct related to the purchasing, cash disbursement, payroll, and fixed assets processes. Many of those issues are also pertinent to the conversion system, as the relevant business activities also correspond to processes in the conversion system.
In addition, the conversion system is the target of many types of fraud schemes. Most of these involve the falsification of inventory quantities, hiding of inventory costs, or manipulation of the gross profit figure. These types of fraud schemes are generally perpetrated by management in an attempt to meet or beat earnings targets. Earnings management is the act of misstating financial information in order to improve financial statement results.
One method used by managers to increase the gross profit is to offer price discounts to customers. Although many companies offer price discounts, there may be a problem with this scenario if the intention of management is to artificially boost earnings. Sales discounts become problematic when they are offered as a coercive tactic to lure customers into making a purchase earlier than normal. Although it may be an effective way to increase sales, there are ethical implications to this practice. Customers will expect the discounted prices to be offered in the future, and the temporary increase in cash flow for the company may affect projections that are not likely to be realized.
Another earnings management technique exists whereby managers authorize the production of excessive inventories. This is a method of “gaming” the system by manipulating inventory amounts through the use of absorption costing techniques. Absorption costing involves the inclusion of both variable and fixed costs in the determination of unit costs for ending inventories and cost of goods sold. Thus, absorption costing provides for the transfer of fixed manufacturing costs to the balance sheet (via the inventory accounts) in the period when the inventory is sold. Accountants can take advantage of this system by overproducing inventories. When the amount of inventory produced exceeds the company's requirements to support sales orders, the level of finished goods inventories increases. The more inventory units that are on hand, the greater is the proportion of fixed costs that will be allocated to the balance sheet. If normal inventory levels had been maintained, a greater proportion of fixed costs would have been allocated to cost of goods sold and reported on the income statement as a deduction from sales.
THE REAL WORLD
In the early 1990s, an inventory fraud scheme was discovered at F&C International, Inc. F&C is a manufacturer of flavors and fragrances, with operations in New York and Cincinnati. Its founder and majority owner, Jon Fries, engaged in a series of frauds, all of which involved the conversion process. Fries mislabeled inventory items in order to overstate their value, recorded fictitious production and shipping activities, and falsified sales figures in an at tempt to meet projections. He even appointed a task force of employees who were ordered to carry out these plans. The task force was also instructed to alter reports and destroy certain supporting documentation. His motive for committing these crimes was threefold: He desired to increase profits in order to improve the reputation of the company, improve his relationship with the company's debtors in order to expand his borrowing potential, and increase his own compensation. Fries was convicted of fraud and served a prison sentence. The frauds he orchestrated led to the company's ultimate downfall.
Another ethics issue related to the conversion process involves the ethical decisions encountered as the processes become more automated. Management should consider the moral implications of replacing human resources with electronic resources. To the extent possible, management should take an active role in the reassignment (rather than termination) of personnel when production jobs are eliminated as a result of automation.