Arthur Chen, a newly minted CPA, was on his second audit job in the Midwest with

Question

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 last 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 2011. 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?

Explanation / Answer

a)Current ratio is Current assets/ Current liabilities. It gives a rough idea of companies financial health. It is a companies ability to pay back its current liabilities with its current assets. It gives an estimate about the ability of the company to turn its product into cash. In the given case, Parson's customers returned products to the company due to substandard quality. So, the accounts receivable could not be converted to cash, instead they were credited and some long term asset was debited. This reduced the current assets and thus, reduced the current ratio.

b) If current ratio is high, it indicates that resources are not being utilized fully. It would indicate that the company is keeping more ' margin of safety ' that required , it has resources tied up in working capital and not put to use in profitable ways.THerefore, lower current ratio implies the other way around and indicates that the company resources are put to use in profitable ways.

Also, high current ratio means excessive cash. The excess costs reduce the profits of the company with implied interest costs. So, lower current ratio means more growth for the company.

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