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.”

What is the effect on income before taxes of the sales transaction requested by the CFO? 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?

Answer 1

Horizon Corporation manufactures personal computers. The company began operations in 2012 and reported profits for the years 2012 through 2019.

1. The consequence on income before taxes of the sales operation requested by CFO will be that its income before taxes will increase, pertaining to reporting of fake 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: 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.

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.

Analysis: In the given case, the company under question, i.e. Horizon Corporation is reporting losses already in the year 2021 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.