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 pur-
chase 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 busi-
ness operations in three foreign countries. At year-end, the company’s auditors
insisted that man-
agement 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 Elliot-Cole’s assets in these three
countries
should be reduced to “scrap value”—which was nothing. These write-downs
amounted to approxi-
mately 18 percent of the company’s income prior to 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 be 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?