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Red Corporation had a temporary cash squeeze near its balance sheet date. It needed cash badly for a seasonal dip in sales. However, a loan covenant requiring a certain debt/equity ratio would be violated if any additional money were borrowed. To remedy this,the top two officers of the Red Corporation set up another corporation,Pink,Inc. Red Corporation made a large sale of inventory to Pink, Inc. at cost. Pink, Inc. used the inventory as collateral for a three month loan from a local bank. Them money from the loan was used to pay Red Corporation for the accounts receivable resulting from the "sale" At the end of the three month period, the officers intended to have Red Corporation buy back the inventory from Pink, inc. at a price that would allow Pink to pay off the loan plus interest

a.) How would this transaction designed by the two officers enable Red Corporation to maintain its required debt/equity ratio while obtaining the cash it needed?
b.)What test of controls and substantive tests would enable an auditor to detect this scheme?

 

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