Larry Bush, was on his second audit job on the East Coast with a new client call

Question

Larry Bush, was on his second audit job on the East Coast with a new client called FSK. He was looking through the past four years of financials and doing a few ratios when he noticed something odd. The current ratio went from 1.9 in 2011 down to 0.3 in 2012, despite the fact that 2012 had record income. He decided to sample a few transactions from December 2012. He found that many of FSK customers had returned products to the company because of substandard quality. Bush discovered that the company was clearing the receivables but stashing the debits in an obscure long-term asset account called "grain reserves" to keep the company's income "in the black". How did the fradulent accounting just desribed affect the current ratio? Can you think of any reasons why someone in the company would want to take this kind of action?

Explanation / Answer

Current ratio = current assets / current liabilities.

Current ratio will decrease if current assets decrease and/or current liabilities increase. Here, the sales returns are decreasing accounts receivables, which is a curent asset. This is reducing the curent ratio.

However, the debited sales return is being transferred to an obscure account, instead of debiting it from revenue. This is done to inflate/overstate revenue than what is actually is. Higher revenue will result in a higher net profit ceteris paribus, which will add to the company's bottom line and the profitability ratios will be overstated, painting the financial reports a rosy picture. A "Profitable" firm will be a safe bet for investors who will invest more in the firm, its stock price will rise and market capitalization will increase as well.

Related Questions

Navigate

• Browse (All)
• Browse L
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.