Reference no: EM131645395

Question - Elliot-Cole is a publicly owned international corporation, with operations in over 90 countries. Net income has been growing at approximately 15 percent per year, and the stock consistently trades at about 20 times earnings.

To attract and retain key management leadership, the company has developed a compensation plan in which managers receive earnings in the form of bonuses as well as opportunities to purchase shares of the company's stock at a reduced price. In general, the higher the company's net income each year, the greater the benefit to management in terms of their personal compensation.

During the current year, political unrest and economic upheaval threatened Elliot-Cole's business operations in three foreign countries. At year-end, the company's auditors insisted that management write off the company's assets in these countries, stating that these assets were "severely impaired" Said one corporate official, "We can't argue with that. Each of these countries is a real trouble spot. We might be pulling out of these places at any time, and any assets probably would just be left behind."

Management agreed that the carrying value of Elhot-Cole's assets in these three countries should be reduced to "scrap value"-which was nothing. These write-downs amounted to approximately 18 percent of the company's income priorto recognition of these losses. [These write-offs are for financial reporting purposes only: they have no effect on the company's income tax obligations.)

At the meeting with the auditors, one of Elliot-Cole's officers states, "There's no doubt we should write these assets off. But of course, this is an extraordinary loss. A loss of this size can't be considered a routine matter."

Instructions

a. Explain the logic behind writing down the book values of assets that are still in operation.

b. Evaluate the officer's statement concerning-the classification of these losses. Do you agree that they should he classified as an extraordinary item? Explain.

c. Explain the effect that the classification of these losses-that is. as ordinary or extraordinary- will have in the current period on Elliot-Cole's:

1. Net income.

2. Income before extraordinary items.

3. Income from continuing operations.

4. Net cash flow from operating activities.

d. Explain how the classification of these losses will affect the p/e ratio reported in newspapers such as The Wall Street Journal

e. Does management appear to have any self-interest in the classification of these losses? Explain.

f. Explain how (if at all) these write-offs are likely to affect the earnings of future periods.

g. What *ethical dilemma* confronts management in this case?