Week 5 Discussion Question 1 & Week 5 Dicussion Question 2

Ethical Obligations and Decision Making in Accounting, 4/e 1 © 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Case 7-6 Sweat Hog Construction Company (Mintz & Morris 2017)

During the past few years due to increasing competition, Sweat Hog Construction

Company has been more aggressive in seeking out new business opportunities. One such

opportunity is the Computer Assistance Vocational Training School. It has contracted for

a new 1-million-square-foot facility in San Marcos, Texas. Computer Assistance trains

computer programmers for jobs in business and government. It is the largest computer

training school in the southwestern United States.

Gabe Kohn is the passive owner of Sweat Hog Construction. The company began

operating in 2000, when Kohn hired Michael Woody to be the president of the company.

Sweat Hog Construction is a family-owned business that has been very successful as a

mechanical contractor of heating, ventilation, and air-conditioning systems. However,

increased competition has put pressure on the company to diversify its operations.

Although it made a profit in 2011, the company’s net income for the year was 50 percent

lower than in previous years. As a result of these factors, the company decided to expand

into plumbing and electrical contract work.

In March 2012, Sweat Hog Construction successfully bid for the Computer Assistance

job. The company bid low in order to secure the $3 million contract that is expected to be

completed by June 30, 2013. Woody knows that the company has little margin for error

on the contract. The estimated gross margin of 11.5 percent is on the low side of

historical margins, which have been between 10 to 15 percent on heating, ventilation, and

air-conditioning contracts. Because it is a fixed-price contract, the company will have to

absorb any cost overruns.

The Computer Assistance contract is an important one for Sweat Hog Construction. It

Ethical Obligations and Decision Making in Accounting, 4/e 2 © 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

represents about 20 percent of the average annual revenues for the past five years.

Moreover, First National Bank of Texas has been pressuring the company to speed up its

interest payments on a $2 million term loan payable to the bank that is renewable on

March 15, 2013. The company has been late in five of its last six monthly payments. The

main reason is that some of the company’s customers have been paying their bills later

than usual because of tight economic conditions. However, the company expects to get

back on the right track very soon after the Computer Assistance job begins.

Everything started out well on the contract. For the quarter ended June 30, 2012, Sweat

Hog Construction had an estimated cumulative gross profit of $75,000 on the contract

under the percentage-of-completion method. This represents a 20 percent gross margin.

Costs started to increase during the September quarter and, even though cumulative gross

margin decreased to 10 percent, it was still within projected amounts. Unfortunately, the

$54,000 estimated gross profit for the nine months ended December 31, 2012, represents

only a 3 percent gross margin for the first year of the contract. Exhibit 1 contains cost

data, billings, and collections for the year.

Exhibit 1

Ethical Obligations and Decision Making in Accounting, 4/e 3 © 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Sweat Hog Hog Construction

Company Computer Assistance Contract

Year Ended December 31, 2012

Quarter Ending

June 30 September 30 December31

Costs to date $ 300,000 $ 900,000 $1,740,000

Estimated costs to complete 2,100,000 1,800,000 1,170,000

Progress billings each quarter 250,000 600,000 950,000

Cash collections each quarter 150,000 350,000 400,000

Vinny Barbieri is a CPA and the controller of Sweat Hog Construction. Barbieri knows

that cash collections on the Computer Assistance project have been slowing down—in

part, because the company is behind schedule—and tension has developed between the

company and Computer Assistance. He decides to contact Juan Santos, general manager

for the project. Santos informs Barbieri that the tension between the company and

Computer Assistance escalated recently when Santos informed top management of

Computer Assistance that the electrical work may not be completed by the June 30, 2013,

deadline. If the facility does not open as scheduled for the summer months, Computer

Assistance may be required to return deposits from students. Consequently, it may lose

out on the revenue that is projected for the July and August summer term.

Woody calls for a meeting with Santos and Barbieri on February 6, 2014, to discuss

the Computer Assistance contract. Woody knows that Sweat Hog Construction’s external

auditors will begin their audit of the December 31, 2013, year-end financial statements in

two weeks. Woody wants to make sure the problems with the contract have been

Ethical Obligations and Decision Making in Accounting, 4/e 4 © 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

corrected. He asks Barbieri to bring him up to date on the recent cost increases on the

contract.

Barbieri informs Woody that the internal job cost data indicate that $420,000 was

incurred for the month of January 2014. About 10 percent of the work was completed

during that month. Barbieri emphasizes that this is consistent with recent trend data that

indicate the estimated costs to complete the contract have been significantly understated.

In fact, for the quarter ended December 31, 2013, the company lost approximately

$40,000 on the contract, although there is a cumulative gross margin of about $60,000 for

2013. However, this cumulative margin represents only 2 percent of revenue, and the

gross margin percentage is declining. Barbieri analyzed the cost data in preparation for

the meeting. He estimates that total costs on the contract may be as high as $4.2 million.

He recommends that the $1.17 million estimate to complete the contract at December 31,

2014, should be increased by at least $1 million.

Woody is stunned by this information. He cannot understand how the company got

into this predicament. The company has consistently made profits on its contracts, and

there has never before been any tension with clients. The timing is particularly

troublesome, since First National Bank is expecting audited financial statements by

March 1, 2013. Woody asks Santos whether he agrees with Barbieri’s assessment about

the anticipated higher level of future costs. Santos hesitates, at first, but he eventually

admits to the likelihood of cost overruns. He points out that the workers are not as skilled

with electrical work as they are with heating, ventilation, and air-conditioning work.

Consequently, some degree of learning is taking place on the job.

Woody dismisses Santos at this point and asks Barbieri what would happen if the

Ethical Obligations and Decision Making in Accounting, 4/e 5 © 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

company reports the estimated costs at December 31, 2012, without any adjustments.

Woody emphasizes that the company would make the necessary adjustments in the first

quarter of 2013, and gross profit on the contract with Computer Assistance ultimately

will be correct. This approach would enable the company to renew its loan and give it

some time to rethink its business strategy.

Barbieri immediately tells Woody that he is not comfortable with this approach, since

the profit on the contract for the nine months ended December 31, 2012, would be

significantly overstated. He points out that the auditors are likely to question the low cost

estimates. Woody becomes a bit irritated with Barbieri at this point. He tells Barbieri that

the bank is not likely to renew the company’s $2 million loan if the statements reflect

what Barbieri suggests. He concludes by stating: “The auditors have never been a

problem before. I do not expect any problems from them on this issue either, given that

the firm has gone along with whatever we’ve asked of them in the past.”