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 office (CFO) to Jim Filed, 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 2021which 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.

Answer the following questions (either with a video or written).

1. What is the effect of this transaction, requested by the CFO, on net income?

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

3. Are investors and creditors potentially harmed by the CFO's suggestion?

4. should Jim follow the CFO's suggestion? Support your answer with accounting.

Answer 1

1. The net income in the books of Horizon Corporation will be higher or is increased.

(Although, it is fictious income & sales are manipulated to show higher income, outsiders will not know it for the time being)

2. Value of Total assets and amount of net income will decrease in the books of Horizon Ccorporation due to inventory write down. Write down of Inventory will reduce the Value of Inventory in total assets and such reduction will be charged to the income account.

3. Yes. This is an accounting fraud. There is all the possibility of harming the interests of Investors and Creditors by following CFO's suggestion.

Unreported or misreported loss in a row for the second year may cause serious liquidity problems for Horizon Corporation. Because of window dressing of finnancial statements and unaware of the company's real situation, the creditors may continue credit supplies. This may affect their ability to collect their outstandings in the future.

New investors may invest in the Company's stock or existing investors may continue with their current holdings guided by window dressed financial statements. Once the market realises real strength of the company, Investors' wealth will erode substantially either in the form of trading common stock or in the bankruptcy proceedings of the company.

Enron accounting scandal is best example.

4. Jim should NOT follow CFO's suggestion at all.

It is an ethical dilemma for Jim. The suggestion of CFO is not the right one for getting out of the current problems faced by the company. The company should focus and make more efforts  on selling unsold computer inventory. Cash discounts, Instalment sales may somewhat reduce the inventory.

Saving from bankruptcy by misrepresentation is not the solution . The problem will not be solved but postponed to a later date to face more complicated existential, legal and ethical issues. Return of inventory by JB sales in the next year will bring back same problems and facing same losses next year.

Moreover, following the suggestion will harm everyone's interests including the creditors, Investors, Employees.

And also the suggestion is against the generally accepted accounting principles of fair presentation of financial statements and full disclosure & against the professional ethics of Integrity , Honesty and Due Diligence.