Question: Management of Statement of Cash Flows, Ethical Issues Fred Jackson, president and owner of Bailey Company, is concerned about the company's ability to obtain a loan from a major bank. The loan is a key factor in the firm's plan to expand its operations. Demand for the firm's product is high-too high for the current production capacity to handle. Fred is convinced that a new plant is needed. Building the new plant, however, will require an infusion of new capital. Fred calls a meeting with Karla Jones, financial vice president. Fred: Karla, what is the status of our loan application? Do you think that the bank will approve? Karla: Perhaps, but at this point, there is a real risk. The loan officer has requested a complete set of financials for this year and the past two years. He has indicated that he is particularly interested in the statement of cash flows. As you know, our income statement looks great for all three years, but the statement of cash flows will show a significant increase in receivables, especially for this year. It will also show a significant increase in inventory, and I'm sure that he'll want to know why inventory is increasing if demand is so great that we need another plant. Both of these effects show decreasing cash flows from operating activities.
Fred: Well, it is certainly true that cash flows have been decreasing. One major problem is the lack of operating cash. This loan will solve that problem. Bill Lawson has agreed to build the plant for the amount of the loan but will actually charge me for only 95 percent of the stated cost. We get 5 percent of the loan for operating cash. Bill is willing to pay 5 percent to get the contract. Karla: The loan may help with operating cash flows, but we can't get the loan without showing some evidence of cash strength. We need to do something about the increases in inventory and receivables that we expect for this year. Fred: The increased inventory is easy to explain. We had to work overtime and use subcontractors to take care of one of our biggest customers. That inventory will be gone by the first of next year. Karla: The problem isn't explaining the inventory. The problem is that the increase in inventory decreases our operating cash flows and this shows up on the statement of cash flows. This effect, coupled with the increase in receivables, depicts us as being cash poor. It'll definitely hurt our chances.
Fred: I see. Well, this can be solved. The inventory is for a customer that I know well. She'll do me a favor. I'll simply get her to take delivery of the inventory early, before the end of our fiscal year. She can pay me next year as originally planned. Karla: Fred, all that will do is shift the increase from inventory to receivables. It'll still report the same cash position. Fred: No problem. We'll report the delivery as a cash sale, and I'll have Bill Lawson advance me the cash as a temporary loan. He'll do that to get the contract to build our new plant. In fact, we can do the same with some of our other receivables. We'll report them as collected, and I'llget Bill to cover. If he understands that this is what it takes to get the loan, he'll cooperate. He stands to make a lot of money on the deal. Karla: Fred, this is getting complicated. The bank will have us audited each year if this loan is approved. If an audit were to reveal some of this manipulation, we could be in big trouble, particularly if the company has any trouble in repaying the loan. Fred: The company won't have any trouble. Sales are strong, and the problem of collecting receivables can be solved, especially given the extra time that the 5 percent of the loan proceeds will provide.
Required: 1. Form a group with two to four other students. Discuss the propriety of the arrangement that Fred has with Bill Lawson concerning the disbursement of the proceeds from the loan.
2. In your group, discuss the propriety of the actions that Fred is proposing to improve the firm's statement of cash flows. Suppose that there is very little risk that the loan will not be repaid. Does this information affect your assessment?
3. Assume that Karla is subject to the Institute of Management Accountant's (IMA) code of ethics. Look up this code, and identify the standards of ethical conduct that will be violated, if any, by Karla should she agree to cooperate with Fred's scheme.
4. Using the IMA code of ethics, if you were in Karla's position, what would you do (suppose that Fred insists on implementing his plan)? Now, answer the question assuming that Fred is willing to consider alternative ways to solve the company's problems.