Question

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, the 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 write-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 which will boost our loss to a profit. Then J.B. Sales will simply return the inventory in 2022 after the financial statements have been issued.”

1. Understand the reporting effect: What is the effect on income before taxes of the sales transaction requested by the CFO?

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

3. Identify the impact: Are investors and creditors potentially harmed by the CFO’s suggestion?

4. Make a decision: Should Jim follow the CFO’s suggestion?

Answer 1

1)

The income before tax increase by the same amount as gross margin on the sales requested by the CFO

2)

If Jim does not record the sales transaction requested by the CFO, it decreases the value of inventory and affects the income statement and shareholder capital in the balance sheet and also affects the inventory balance in the balance sheet by the same amount as value of inventory.

3)

Yes, the creditors and investors are potentially harmed by the CFO decisions, the investor invests their money after influencing the profit of the horizon corporation but in reality there is no profit and the investor loses their money in the coming year. The creditor also has the counterparty risk, if the horizon corporation is unable to pay the payment of creditors in the coming years.

4)

No, Jim should not follow the CFO suggestion, because it is not fair to present misreporting in the financial statements and defraud the creditors, investor and lender. It damages the reputation of the organization and the investor loses their faith in organizations.