Managerial accounting principles and applications

Managerial Accounting

Sue Davis is faced with an ethical dilemma with regards to the allocation of $2 million in research and development funding. According to company policy, she is obligated to allocate the funds to Project K3. Doing so will result in the project taking a loss. This will impact corporate profitability and result in Davis forgoing her bonus. If she allocates the funding to two new projects, she may be able to retain the profitability and the bonus. Although this practice is expressly prohibited, the risk of detection is low (Cohen, Pant & Sharp, 2000).

It is proposed that Sue allocate the funds to K3 as policy requires. Sue's decision-making process does consider her personal gain in that she is subject to an incentive system whereby she has the potential to benefit personally from her allocation decision, to the detriment of other stakeholders. There are three factors that influence this decision. The first is her reputation, which would be damaged if K3 comes in at a loss. The second is the direct reward to Davis, which would be her $20,000 bonus. The third is the profitability of the company, which will take a hit if the project comes in at a loss. However, Davis risks doing considerably more damage to her career if she improperly allocates these costs and is discovered. Such an act would violate the agency relationship with the company and its shareholders and this type of violation is considered to be very serious by the company.

As the VP of Research & Development, I recommend the following steps to ensure proper allocation of costs. The first is that cost allocations be subjected to periodic audit. This increases the likelihood of improper allocations being discovered. The second recommendation is to improve our cost tracking systems. This will make the audit process easier. The third recommendation is to institute mid-project cost reports. That we do not find out about cost overruns until the project is completed creates a climate where managers are motivated to overlook past transgressions yet are powerless to address future ones. Lastly, I would tie performance-based bonuses either to non-financial measures or to ones based on financial accounting, subject to GAAP and other defined rules and procedures. In general, financial incentives are only necessary when there are competing incentives (Jensen, 1994); that is not the case here.

1. Sue faces multiple challenges. She has cost overruns on her major project; her incentives do not correspond with what is best for the company (agency problem); and she may embarrass the company if the project comes in over budget. She has few tools with which to work. She has basic financial statements and managerial accounting statements. There were no interim statements to help her gauge the financial status of K3 or the new projects, factors that could influence her decision-making throughout this process.