Arthur Chen, a newly minted CPA, was on his second audit job in the Midwest with a new client called Parson Farm Products. 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 2016 down to 0.3 in 2017, despite the fact that 2017 had record income. He decided to sample a few transactions from December 2017. 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” rather than debiting Sales Returns and Allowances 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?
2. Can you think of any reasons why someone in the company would want to take this kind of action?
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