Question

Expand Your Critical Thinking 12-9 (Essay)

Pendleton Automotive Corp. is a medium-sized wholesaler of automotive parts. It has 10 stockholders who have been paid a total of $1 million in cash dividends for 8 consecutive years. The board’s policy requires that, for this dividend to be declared, net cash provided by operating activities as reported in Pendleton Automotive’s current year’s statement of cash flows must exceed $1 million. President and CEO Hans Pfizer’s job is secure so long as he produces annual operating cash flows to support the usual dividend.

At the end of the current year, controller Kurt Nolte presents president Hans Pfizer with some disappointing news. The net cash provided by operating activities is calculated by the indirect method to be only $970,000. The president says to Kurt, “We must get that amount above $1 million. Isn’t there some way to increase operating cash flow by another $30,000?” Kurt answers, “These figures were prepared by my assistant. I’ll go back to my office and see what I can do.” The president replies, “I know you won’t let me down, Kurt.”

Upon close scrutiny of the statement of cash flows, Kurt concludes that he can get the operating cash flows above $1 million by reclassifying a $60,000, 2-year note payable listed in the financing activities section as “Proceeds from bank loan—$60,000.” He will report the note instead as “Increase in payables—$60,000” and treat it as an adjustment of net income in the operating activities section. He returns to the president, saying, “You can tell the board to declare their usual dividend. Our net cash flow provided by operating activities is $1,030,000.” “Good man, Kurt! I knew I could count on you,” exults the president.

Answer 1

Ans :

As per the Accounting Fundamentals Liability is a debt for the business and is to be payable (payback) on a short or long term basis as per the classification of Liability. Basically it is an outcome from a financing activity.

Operating activity outcome can be defined as the cash proceeds derived by the operational or income producing activity of the organisation, like manufacturing, assembling, trading etc.

Note Payable can be defined as a current liability on the condition that it should be due within one year period. Over here it is specified as a 2 year Note payable, hence it is a non current liability.

In this example Mr Kurt, the controller of Pendleton Automotive Corp is trying to manipulate accounts by wrongly defining Notes payable as current liability and showing the cash proceeds from it as operating cashflow which is ethically financing cashflow.

Dividends are to be paid from the free cashflows of the firm arriving by the basic activity of the business or by the income generated from the business activities. Declaring dividends on the basis of debt cashflow of the business i.e Note payable is a totally insane decision and hence does not comply with the accounting principles.

Therefore the Act by Mr Kurt and the approver of this Act Mr Hans re both liable to the fraudulent activity done by manipulating and misrepresenting accounting records and would be liable to punishment when caught in periodic Audit of accounting records.

Such acts not only hampers within the organisation employees and there trust upon the company management but also the creditors and investors to think and make there investment decision.

So it can be concluded a small change in the accounting records could give severe and long term effects for the organisation and its future.