ACCOUNTING FOR DECISION MAKING (ACC7101)

ASSOC. PROF. DR. AHMED RAZMAN ABDUL LATIFF

GROUP ASSIGNMENT: SCREEN MICROTECH INC.

27 NOVEMBER 2021

GROUP 7
WONG YI HAO PBS21101073 YIHAO
AZLINDA BT MOHD NADZRI PBS21101007 LINDA
YEE YEE
CHEW YEE YEE PBS21101018 VINOD
VINODH ANBALAGAN PBS21101005 SYAHRU
SYAHRUL GHANI BIN ZAINAL ABIDIN PBS20301261 L
27 NOVEMBER 2021
 GROUP ASSIGNMENT REPORT

SCREEN MICROTECH INC.

PREPARED BY: GROUP 7

NAME STUDENT NO.

Wong Yi Hao PBS21101073
Azlinda Bt Mohd Nadzri PBS21101007
Chew Yee Yee PBS21101018
Vinodh Anbalagan PBS21101005
Syahrul Ghani Bin Zainal Abidin PBS20301261

ACCOUNTING FOR DECISION MAKING (ACC7101)

ASSOC. PROF. DR. AHMED RAZMAN ABDUL LATIFF

PUTRA BUSINESS SCHOOL

MALAYSIA 27 NOVEMBER 2021

TABLE OF CONTENTS
No. Table of Contents Page Number

1.0 Introduction 1

2.0 Question 1: You are a financial analyst and have been 1

asked to prepare a fair, unbiased assessment of SMI's
financial performance prior to its IPO. Based on your
review and analysis, write a short report to senior
management, addressing each key accounting transaction
described in the case.
2.1 Provision for Returns on Sales
2.2 Machine depreciation 1
2.3 Research and Development expenses 3
2.4 Gain on sales 7
2.5 Shipment Damage and Revenue Recognition 8
2.6 Comparison between current and adjustment of SMI 9
Financial Statement for the Fiscal Year 2015 10

3.0 Question 2: Is SMI's accounting ethical? Does it feature 11

earnings management or earnings manipulation? What is
the difference between the two, if any?

4.0 References 13

5.0 Table of Tables 13

1.0 Introduction

Screen Microtech is a screen manufactured company that is privately owned. They are
planning to go for an IPO in 2016. Most of the income and revenue come from a customer
that is having a strong relationship with Deltech. In order to achieve an IPO by Derby and
Henderson, we need to go through the financial statement and provide the solutions
accordingly by adjusting the figure to the statement in order to beautify the statement. The
problem can be the depreciation method that they used, the shipment damage, the return on
sales, the gain on sales, or the R&D expenditures that they allocated. All of these will need to
be reinvestigated and calculated properly in order to meet the objectives which are to come
out with a proper financial statement.

2.0 Question 1: You are a financial analyst and have been asked to prepare a fair,
unbiased assessment of SMI's financial performance prior to its IPO. Based on your
review and analysis, write a short report to senior management, addressing each key
accounting transaction described in the case.

Following is our comment and recommendation after reviewing and analysing each
important accounting transaction disclosed in the case.

2.1 Provision for Returns on Sales

Based on the case, we can observe that no provision for return and bad debt was
recorded in 2013 and 2014 since they have a solid relationship with Deltech, and Deltech's
needs are predictable and constant. If any smaller accounts resulted in bad debts, a direct
write-off policy was implemented. Under Derby's leadership in 2015, SMI expanded and a
number of new clients were discovered, while Deltech remained a key customer. According
to historical data, 2% of Deltech products were returned, and new sales projected an overall
average of 5% returns. SMI, on the other hand, has decided to provide a 3% return on sales
rather than a 5% return on sales due to the fact that their sales in 2015 were not solely due to
Deltech, but also to new client that contribute 33% in sales increase, so they choose an
average rate of 3% for provision for return on sales. For the calculation of the average
provision rate for return on sales, we can refer to the Table 1 below.

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 Gross Sales Justification
$11,255,000 33% of sales contribute by new client
$22,847,000 Sales contribute by Deltech
$34,100,000 TOTAL GROSS SALES 2015

Provision rate Gross Sales 2015 Provision for return 2015

2% (Deltech) $22,847,000 $ 456,940

5% (New client) $11,255,000 $ 562,750
TOTAL $34,100,000 $ 1,019,690
Calculation for average rate of provision rate for return on sales
1,019,690/34,100,000 = 3%

Table 1: Calculation for the average rate of provision for return 2015

In 2015, we can see that new clients are coming in and contributing 33% of the sales.
These firms had large contracts with large corporations such as Samsung and LG. Because
this new client brings more business to SMI, SMI offers more lenient return policies and
payment terms. SMI predicted that the provision for return would increase because the new
screen that they produce had to be adapted to a variety of manufacturing processes, and SMI
may be inexperienced in this, resulting in SMI failing to meet the new client's expectations
because the new client is very selective on this. The company is debating whether to use a 3%
or 5% return on sales, so for the reasons stated above, it is recommended that SMI use a 5%
return on sales rate. The following calculation shown the different for 3% and 5% provision
of return on sales

3% Returns 5% Returns
Gross Sales $34,100,000 $34,100,000
(-) Provision for bad debts ($ 682,000) ($ 682,000)
(-) Provision for return ($ 1,023,000) ($ 1,705,000)
Net Sales $32,395,000 $31,713,000
Cost of Goods Sold $24,357,000 $24,357,000
Gross Profit $8,038,000 $7,356,000
Total Operating Expenses $6,810,520 $6,810,520
Income from continuing $1,227,480 $545,480

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 operations
Gain on sales of production $9,500,000 $9,500,000
facilities
Net Income $10,727,480 $10,045,480

Table 2: Comparison between 3% and 5% rate of provision for return on sales

Based on Table 2, we can see that the difference in provision for return on sales of 3%
& 5% is $682,000. We can say that the net income is overstated by SMI if they adopted a 3%
rate. In conclusion, based on the reasons stated above, it is recommended that SMI adopt a
5% rate of provision for return.

2.2 Machine depreciation

Previously SMI have been using the double declining method to calculate the
depreciation for the machine that they have bought in for a 5 years life cycle. But after the
discussion, the company decided to switch to a straight-line depreciation method in order to
simplify the financial report to the stakeholder to have a better understanding and reduce the
expenses of depreciation expenses. This will make the financial report looks more
presentable to the stakeholder by having a higher net income by reducing the depreciation
cost expenses. But there are some aspects that need to be looked after when they are changing
the depreciation method. The aspects can be from the financial part and future provision part.

Below is the table for the double declining depreciation method for previous year.

Table 3: Double declining depreciation method

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 Formula for the calculation will be the net book value divided by the years of life
cycle, then times 2. Due to the life cycles of the machine will be 5 years, the rate will be ⅕ x
0.2 x 2 which is 0.4 for the double declining method. The reason why the net book value for
2015 increased to $10,777,600 is because the company will buy a new machine every 5 years
due to the machine life cycle being only 5 years.

Below will be the table for implementing the straight-line method for depreciation.

Table 4: The straight-line method for depreciation

Formula will be the net book value divided by the amount of year that will be used for
the equipment life cycle. The depreciation factor will be ⅕ =0.2. Each year the company will
need to divide the net book value by 0.2 in order to calculate the depreciation cost.

Criteria Straight line Double declining

method method

Gross profit $8,038,000 $8,038,000

Equipment depreciation $2,155,520 $4,311,040

Operation expenses $4,655,000 $4,655,000

Income from operation $1,227,480 -$928,040

Gain on sale $9,500,000 $9,500,000

Net income $10,727,480 $8,571,960

Table 5 : Comparison between straight line method and double declining method

As a comparison in table 5, we can see that the double declining method is costing the
company more than the straight-line method. It is true that the company will have a more

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presentable financial report by implementing the straight-line depreciation method. By
looking at the net income, straight line methods are having $10,727,480 while double
declining methods are having only $8,571,960, it is a gap of $2,155,520 of net income in
between two depreciation which cost almost 20 percent of the profit margin. But to run the
company, financial analysis will not only be the only part that needs to be overlooked. The
non-financial part will need to be taken care of as well. This is to have proper planning and
provision for the future of the company's financial condition as well.

Criteria Advantages Disadvantages

Double declining - Minimum loss at the - Poor net income

method disposal of the machine. performance.
- Reduces tax obligation. - Low dividend.
- Matching the life cycle - Value of assets can
of machine never be 0

Straight line method - Simplicity. - Pressure on final year.

- Better net income. - Does not have provision
- Asset’s value can be 0. for machines.
- Interest loss.

Although the net income is lower than the straight-line method, our group still
recommends the company to continue the depreciation calculation by using the double
declining method. For a manufacturer company such as Screen Microtech Inc, the machine
will be operating for full working hours. Most of the machine will be performing to its full
potential when the condition of the equipment is still new. At this stage, the production and
the value of the machine will be much higher compared to the depreciation cost due to the
calculation having been done on average. But the machine will have the aging problem which
will cost more maintenance fees in the future and the fees may overload the depreciation cost.

Besides, by having the aging problem, the productivity for the machine will be lower
from year to year as well. This is because the machine will have a limitation when a part of
the equipment is broken. As the year increases and productivity keeps dropping, the company
may face pressure at the end of the year if the depreciation is calculated by using the straight-
line method due to the operating expenses of the machine having increased but the

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productivity has become lower which will consequently cause a lower net income to the
company.

All of these will be the risk of having a straight-line method but can be overcome by
the double declining depreciation. This is because the provision of the aging problem in the
equipment can be overcome by prediction and covered in the depreciation cost. In the final
year financial report, although the productivity of the machine has become lower, the
depreciation cost has reduced as well and this will make the financial statement more
convincing and presentable to the stakeholders.

Apart from that, the company has decided that the machine will only have a 5 years
life cycle and the machine will be purchased again after 5 years. It is more convincing and
suitable to have the double declining method if at the end of the day the machine will be
having 0 net value. Having sudden changes in the depreciation method also makes the
company look aggressive in increasing the net income just for their IPO in 2016.

2.3 Research and Development Expenses

Income Statement (Revised)

2015 before
2015 after changes
changes
Gross Sales $34,100,000 $34,100,000
Less: Returns 0 0
Less: Provision for Bad Debts -$68,200 -$68,200
Less: Provision for Returns -$1,023,000 -$1,023,000
Net Sales
$32,395,000 $32,395,000
Cost of Goods Sold $24,357,000 $24,357,000
Less: Loss of Inventory
Gross Profit $8,038,000 $8,038,000
Operating Expenses

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 Lease Expense $420,000 $420,000
Executive Salaries $1,555,000 $1,555,000
Office Salaries $1,525,000 $1,525,000
Depreciation Expense
— Production Equipment $2,155,520 $2,155,520
Office Expense $95,000 $95,000
Advertising Expense $195,000 $195,000
Interest Expense $115,000 $115,000
R&D Expense $750,000 $2,000,000
Total Operating
$6,810,520 $8,060,520
Expense
Income from Continuing
$1,227,480 -$22,520
Operations
Gain on sale of production
$9,500,000 $9,500,000
facilities
Net Income $10,727,480 $9,477,480

To diversify the company’s products, SMI has invested in research and development
costs. This can be observed from 2013 to 2014, where the research and development
expenses have increased from $125,000 to $175,000. Moreover, for 2014 to 2015, research
and development has significantly increased from $175,000 to $2,000,000. However, due to
the benefits of research that would only be realized in 2016, Derby and Henderson both
agreed to recognize $750,000 in research and development cost in 2015 and deferred the
$1,250,000 remaining in 2016. Based on IAS38, all expenses on research are channelled
directly to profit or loss and the expenses for development can only be capitalized if they
meet specific criteria. However, since SMI is based in the USA, the rules for accounting here
are governed by GAAP standard, in which it is stated that it is mandatory for all research and
development expenses to be charged as expenses as incurred. Therefore, all the expenses for
research and development should be written off directly in the income statement for the year
2015. By adjusting the research and development cost to its full value. The net income will be
reduced from $10,727,480 to $9,477,480. It is obvious of an overstatement of the income for
2015.

2.4 Gain on sale

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 Gain and sales of asset of the company is sold more than the carrying amount of the
purchased price and minus any subsequent depreciation and impairment charges. If the asset
is a fixed asset, verify that it has been depreciated through the end of the last reporting period.
If the asset had previously been classified as held for sale, it should not have been depreciated
since it was classified as such, which is acceptable. For SMI’s company, there is an asset to
be able to sell $12 million of its production plant. The table below shows of the activity.

Description Amount ($)

Cash 12,000 000.00
Factory building cost 10,000 000.00
The net book value 2,500000.00
Accumulated 7 500 000.00
depreciation (cost-NBV)
Gain on sale 9 500 000.00

A net book value or net asset value was currently recognized at 2.5 million. SMI had
previously purchased this land and building for production at $10 million. The gain on sales
should be calculated through subtraction of 12 million with 2.5 million. From this
information, Derby obtains 9.5 million of gain on sale. According to SMI’s financial
statement for the fiscal year 2015, the gain on sale effect increases the income from
operations from $1,227,480 to $10,727,480, a total of $9.5 million indifference. The
operation was generated at a lower profit and its lower than 33 percent of sales income.
Consequently, is not mainly due to operating activities but the surge is mainly due to gain on
sales of the factory building and it is not a good report statement for investors to determine
the profitability of a company over time. SMI points out that the net book value of the old
land and building is a sunk cost. It cannot affect any future cost the company might incur and
is irrelevant to the replacement decision.

2.5 Shipment Damage and Revenue Recognition

A truck carrying $7 million worth of touch screens overturned on 27 December 2015.

The shipment cost was $5 million and 20% of the shipment was reported damaged upon
inspection. Client agreed to the new delivery date on 20 January 2016 after further inspection
and repackage on the remaining goods.

8
 As SMI was practising free on-board destination delivery method, they are
responsible for the goods that are damaged or destroyed during shipping. The $1 million loss
of damage beared by SMI as loss of inventory in the income statement. According to the
matching concept, the revenues and related expenses are required to be recognized in the
same financial period. The $7 million revenue booked in December should be removed and
recognized only after delivery in January 2016. The gross sales decreased from $34,100,000
to $27,100,000. $5 million should be removed from the cost of goods sold and reported upon
the sales that happened in 2016. The cost of goods sold was $19,357,000 after deducting the
$5 million.

In addition, we suggest SMI buy shipping insurance which covers unexpected

incidents such as delivery delays and damage to goods. With the insurance, SMI may get
compensation when an accident happens, and to cut loss.

9
2.6 Comparison between current and adjustment of SMI Financial Statement for the
Fiscal Year 2015

Adjusted SMI’s Financial Statement for Fiscal Year 2015

Particulars Income Adjusted Adjustment
Statement Income
2015 ($) Statement
2015 ($)
Gross Sales 34,100,000 27,100,000 Sales are reduced by $7M because the
shipment delayed and sales should be
recognised when the goods are
Less: Returns (0) (0) delivered.
Less: Provision for Bad (682,000) (542,000) 2% from Gross Sales
Debt (1,023,000) (1,355,000) 5% from Gross Sales
Less: Provision for Returns 32,395,000 25,203,000
Net Sales 24,357,000 19,357,000 Less $5 million for shipment delayed
Cost of Goods Sold (0) (1,000,000) 20% from $5 million good damaged
Less: Loss of Inventory 8,038,000 4,846,000
Gross Profit
Operating Expenses 420,000 420,000
Lease Expenses 1,555,000 1,555,000
Executive Salaries 1,525,000 1,525,000
Office Salaries
Depreciations Expenses – 2,155,520 4,311,040 Maintain using double declining method
Production Equipment 95,000 95,000
Office Expenses 195,000 195,000
Advertising Expenses 115,000 115,000
Interest Expenses 750,000 2,000,000 R&D cost previously understated
R&D Expenses 6,810,520 10,216,040
Total Operating Expenses
Income from Continuing 1,227,480 -5,370,040
Operations
Gain on sales of production 9,500,000 9,500,000
facilities 10,727,480 4,129,960
Net Income

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3.0 Question 2: Is SMI's accounting ethical? Does it feature earnings management or
earnings manipulation? What is the difference between the two, if any?

After adjusting the transactions in the financial statements for fiscal year 2015, the
total net income has decreased from $10,727,480 to $4,129,960 when compared to the Net
Income before adjustment. There is a reduction of $6,597,520 from the current net income.
We can see that SMI is engaging in unethical accounting practises by withholding certain
information from stakeholders and distorting accounting data and information in order to
present a high profit financial statement in order to help their company be valued for an IPO,
which will result in a significant bonus for Derby and Henderson as well.

Earnings management is the creative application of various accounting techniques to

improve the appearance of a company's financial reports. It can happen when a corporation is
under pressure to manipulate earnings in order to fulfil specified targets or to convince a
potential investor into investing in the company, even if it means lowering profit in one
accounting period in order to enhance profit in another.

Earning manipulation occurs when a company manipulates financial statements and

violates generally accepted accounting principles (GAAP) in order to favourably represent
the company's financial performance. Manipulation of financial statements can be
accomplished in two ways. The first is to inflate current-period earnings on the income
statement by inflating revenue and gains or deflating current-period expenses. In order to
meet established expectations, this approach makes the company's financial condition appear
better than it is. The second approach involves the exact opposite strategy by deflating
revenue or inflating current period expenses to reduce current period earnings on the income
statement.

The difference between the two is that earning manipulation is an accounting

technique that goes against GAAP and IAS, whereas earning management does not. In the
case of SMI, we can observe that they engage in both earning management and earning
manipulation.

There is one action taken by the SMI company to raise the awareness of the earning
management by the sudden change in their depreciation method towards the machinery. This

11
is because previously they have already been using the depreciation method for the whole
product life cycle and there is no problem in the financial statement due to the product
needing to be replaced every 5 years. There is no need for the company to change their
calculation method on the depreciation. From our opinions, the company is trying to manage
the ways of depreciation by changing to straight line method depreciation in order to get a
higher net income. This will provide a higher chance for the company to claim the IPO
achievement in 2016 like what they wanted in the case study.

Another example of SMI practising earning management is their decision to use a

3% provision for return rather than a 5% provision to reflect greater performance and profit.
Their method does not violate any accounting standards, and the rate is also reasonable and
justifiable.

With regard to earning manipulation SMI have recorded revenue before supplying
goods. Recording revenue prior to product shipment is an earning manipulation. On
December 27, 2017, a truck carrying $7 million in sales was overturned, and the shipment
was delayed until January 20, 2016. SMI has followed an aggressive approach of recognizing
its revenue even when all the criteria for recognizing revenue have not yet been met. Revenue
should be recognised at the point of sale, which is when the seller transfers title to the product
being sold to the buyer or when the services involved in the transaction are completed.
Further, the company has not recorded the loss of inventory in its books of account. By doing
this the company has tried to overstate its profit.

They use this accounting technique because they want SMI's financial statements to
reflect good performance and sales growth as they prepare to go public via IPO, and the IPO
would also result in a substantial bonus for Derby and Henderson. While Derby and
Henderson may want to report higher profits and meet their goal of going public via IPO,
they must also consider how such behaviour will lead to accounting fraud, which will have a
negative impact on SMI. Moving forward, SMI should reconsider their accounting practises
and provide financial statements that adhere to accepted accounting principles.

12
4.0 References

Banton, C. (2021). Free on Board (FOB). https://www.investopedia.com/terms/f/fob.asp

Marshall, D. H., McManus, W.W, & Viele, D.F. (2020). Accounting: What The Numbers

Mean. New York: McGraw-Hill Irwin.

Tuovila, A. (2020). Earnings Management Definition. Investopedia.

https://www.investopedia.com/terms/e/earnings-management.asp

5.0 Table of Tables

Table 1 Calculation for the average rate of provision for return 2015 2
Table 2 Comparison between 3% and 5% rate of provision for return 3
on sales
Table 3 Double declining depreciation method 4
Table 4 The straight-line method for depreciation 4
Table 5 Comparison between straight line method and double 5
declining method

(3,382 words)

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