There are absolutely issues from an ethical and financial reporting perspective. A CEO should
have the rudimentary knowledge of accounting to understand the problems with this plan, so
we can assume that the CEO is knowingly encouraging the accountant to falsify the facts. I
would be looking for a new job. Let us look at this problem.
First, from the reporting standpoint, we can plan as much as we would like, but until expenses
are actually incurred, there is nothing to capitalize (Wahlen et al., 2017). Same with the
"double dose" comment. If there was nothing to capitalize in 2015, why would we double
capitalize in 2016? Second, from the ethics side, we are not going to "add a lot of overhead."
There either is overhead or there is not, and we will not be falsely inflating numbers to
manipulate profits. Doing so challenges the good faith, sincerity, and regularity principles of
GAAP to name a few (FAF 2021). Apply every cent of legitimate overhead, of course, but the
CEO is clearly suggesting that we inflate numbers.
Again, this whole situation is covered in red flags. I would politely explain to the CEO why
his suggestions are baseless from an accounting standpoint and unethical, while also quietly
looking for a way to get as far away from this company as possible.
One thing I noticed first is that you are suggesting of adding the 2015 interest capitalization in
with the 2016 report. This is not acceptable per GAAP standards and Accountants have an
obligation to stand up to these standards. We started construction for our building in 2016 so
we will not be able to capitalize in 2015. Capitalization starts when construction has started
for the building. Overhead costs are the expenses that are not related to direct labor or
materials. My salary falls under administrative expenses or salaries which does not qualify as
overhead cost. We would not be able to put that under our overhead costs.
This is an interesting discussion prompt. It has taken some consideration and these are my
initial thoughts. While the CEO is correct and the planning did indeed start the year before,
there are problems with this request. In this week’s reading it states: “The capitalization
period begins when (1) expenditures for the asset have begun, (2) activities that are necessary
to get the asset ready for its intended use are in progress, and (3) interest cost is being
incurred. Interest capitalization continues if the three conditions are present (Whalen et al.,
2017).” According to this statement, there can be no interest capitalization for 2015, because
while the second factor applies (planning is necessary for building), the other two factors are
not present, therefore there is no interest to capitalize. The textbook is giving us what is
acceptable from the GAAP; this is not accurate and it should not be done and is violative of
those principles. Secondly, adding to the overhead gives an unbalanced view of the profits,
therefore it is not an accurate representation of the profitability and should be avoided.
Because of these factors, I would have to say no, from an accounting standpoint and an ethical
standpoint. To my understanding, GAAP allows for certain interest capitalization, but not to
this extent (Whalen et al., 2017), it should not be done and is a violation of those principles. It
is inaccurate reporting of data from the financial standpoint. And from an ethical standpoint,
while I understand that a business wants to be seen as profitable and in a good financial
position, it feels rather wrong, like it is a misrepresentation. The whole point of accounting is
to give an accurate report, and this feels like number fudging, therefore I would not be
comfortable with it.
My response to the CEO would be something like this: The approach required by GAAP for
interest to be capitalized must address these 3 issues. 1) Does the asset qualify for interest
capitalization? A company can capitalize interest on an asset being constructed for its own
use however it cannot be capitalized for assets that are idle and not undergoing the activities
necessary to get them ready for use. In this case, the request to capitalize the interest from
2015 would not be permissible as construction did not start until June 2016. 2) Over what
period can interest be capitalized? Capitalization begins when expenditures for the asset have
begun, activities necessary to get the asset ready for use are in progress, and interest cost is
being incurred. Again, in this situation we would not be able to capitalize on any interest in
2015 as it does not fit any of the criteria above. 3) What amount of interest can be capitalize?
The portion of interest cost that could have been avoided if construction had not occurred.
Because construction did not begin until 2016 there was no interest cost in 2015 to capitalize
(Wahlen et al., 2017). For these reasons laid out above, I would not be able to “take it out of
this year's expense”, so you can get a “double dose”.
Regarding adding “lots of overhead to the cost of the building to increase profits for this year”
that is also something I would not be able to do. It is unethical and very misleading from a
financial reporting standpoint. Asking me to add 1/12 of my salary as cost of the building
goes against certain core principles of GAAP such as the principle of sincerity, the principle
of regularity, the principle of good faith, and the principle of materiality (GAAP, 2022). For
you to ask this reflects poorly on you as a leader and will reflect poorly on the company, and
for this reason I cannot do as you have asked.
Reference:
Wahlen, James M., et al. Intermediate Accounting: Reporting and Analysis. Cengage
Learning, 2017.
GAAP. Corporate Finance Institute. (2022, February 27). Retrieved from
https://corporatefinanceinstitute.com/resources/knowledge/accounting/gaap/
Whalen, J. M., Jones, J. P., & Pagach, D. P. (2017). Intermediate accounting: Reporting and
analysis. Boston, MA: Cengage Learning.
Tuovila, A. (2021, Aug). Overhead. https://www.investopedia.com/terms/o/overhead.asp
Whalen, J. M., Jones, J. P., & Pagach, D. P. (2017). Intermediate Accounting: Reporting and
Analysis. Boston, MA: Cengage Learning.
Financial Accounting Foundation. (2021). FAF, Financial Accounting Foundation. About
GAAP. Retrieved February 17, 2022, from
https://www.accountingfoundation.org/cs/Satellite?c=Page&cid=1176164538898&pagename
=Foundation%2FPage%2FFAFBridgePage
Wahlen, James M., et al. Intermediate Accounting: Reporting and Analysis. Cengage
Learning, 2017.
