Question

AP6-5 Horizon Corporation manufactures personal computers. The company began operations in 2012 and reported profits for the years 2012 through 2019. Due primarily to increased competition and price slashing in the industry, 2020’s income statement reported a loss of $20 million. Just before the end of the 2021 fiscal year, a memo from the company's chief financial officer(CFO) to Jim Fielding, company controller, included the following comments:

If we don't do something about the large amount of unsold computers already manufactured, our auditors will require us to record a writo down. The resulting loss for 2021 will cause a violation of our debt covenants and force the company into bankruptcy.I suggest that you ship half of our inventory to J.B. Sales, Inc., in Oklahoma City. I know the company's president, and he will accept the inventory and acknowledge the shipment as a purchase. We can record the sale in 2021 whih will boost our loss to a profit. Then J.B Sales will simply return the inventory in 2022 after the financial statements have boon issued.

Required:

1.undersrand the report effect : what is the effect on income before taxes of the sales transaction requested by CFO?

2. Specify the options: if Jim does not record the sales transaction requested by CFO , what is the effect on total asset and income before taxes of the inventory write-down?

3. Identify the impact: are inventors and creditor potentially harmed by the the CFO’s suggestion?

4. Make a decision:should Jim follow the CFO suggestion?

Answer 1

Analysis: In the given case, the company under question, i.e.  Horizon Corporation is reporting losses already in the year 2021. Moreover, it has a lot of unsold stock lying with it, which if reported in its audit report, will violate its debt covenant and force the company into bankruptcy. The company's CFO adviced the company controller Jim to transport all the closing stock to his friend's company and show it as sales which will not only prevent the debt covenant from breaking but will also bail the company out of reporting losses in its Financial Statements.

Solution:

1. The effect on income before taxes of the sales transaction requested by CFO will be that its income before taxes will increase, pertaining to reporting of bogus sales made to J.B. Sales, Inc., in Oklahoma City.

2. If Jim does not record the sales transaction requested by the CFO, the effect on total asset and income before taxes of the inventory write-down will be as follows:

• The company will show all the unsold inventory as closing stock, thus the total assets will increase.
• The company will not show bogus sales in this event, therefore the total sales, as well as Income before taxes, will decrease.

3. The Investors as well as the creditors will obviously be harmed by the the CFO’s suggestion . The impact is discussed as follows:

• The investors will be given misreported financial statements where the actual loss incurred by the company will not be shown but in fact, it'll be veiled by the bogus sales that have been devised by the CEO. This will in a way imply that the company is fooling its investors by painting an image that is cleaner than its reality. The investors will look at that clean image and not bail their funds out of the loss-making company.
• The creditors are definitely being harmed as the company has broken its covenant with the lender by having so many unsold units in its closing stoc, as a result of which the lender has the right to file bankruptcy against the company. The company by reporting the unsold units as its bogus sales is taking that right away from its lenders. They will continue to have their funds invested in the loss-making company, as a result of this misreporting.

4. Jim should not follow the CFO suggestion because he plans to fool the creditors and investors by misreporting its unsold closing stock as bogus sales and then plans to reverse the said entry in 2022 after the audit report will be issued. In this way, he's not only harming the investors and lenders but also Jim, because when in 2022 they will reverse this entry, SEC regulations will apply on the company and both the CFO as well as Jim will be charged with a criminal offence. Thus, Jim should not follow the CFO's advice.