Arthur Chen, a newly minted CPA, was on his second audit job in the Midwest with a new client called Parson Farm Products, Inc. He was looking through the last four years of financials, and doing a few ratios, when he noticed something odd. The current ratio went from 1.9 in 2007 down to 0.3 in 2008, despite the fact that 2008 had record income. He decided to sample a few transactions from December 2008. He found that many of Parson’s customers had returned products to the company because of substandard quality. Chen discovered that the company was clearing the receivables (i.e., crediting accounts receivable) but “stashing” the debits in an obscure long term asset account called “grain reserves” to keep the company’s income “in the black” (i.e., positive income).
1. How did the fraudulent accounting just described affect the current ratio? (Hint: Think about Cash.)
2. Can you think of any reasons why someone in the company would want to take this kind of action?