Nazir Khan, the Ceo of Peshawar Inc Case Study
Nazir Khan, the CEO of Peshawar Inc., signed an employment contract with the company that allowed him to earn a bonus if he increased Peshawar's gross profit margin by more than 3%. The draft income statement for 2018 has just been prepared and is shown below.
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The board of directors is about to meet and determine if Nazir is to be awarded his bonus. As one of the board members, you are surprised to receive an anonymous letter, supposedly from a member of the accounting department, that indicates that the CEO asked the staff member to do the following during 2018:
1. Record purchase returns of $7,000 as an increase of sales revenue.
2. Record freight of $5,000 paid on purchases of merchandise as an operating expense.
3. Record sales returns of $6,000 as an operating expense.
Instructions
(a) Assuming the staff member is right, correct the above adjustments and recalculate the gross profit margin. Is the CEO is eligible for his bonus?
(b) Did the adjustments requested by the CEO affect the profit margin?
(c) Based on the above, was any harm done to any users of the financial statements because of the adjustments made? Explain.
SOLUTION
(a) The CEO asked for three inappropriate adjustments to be made to the financial statements. By recording a purchase return as an increase in sales revenue, the sales revenue is now overstated and cost of goods sold is also overstated. By recording freight-in relating to inventory that has now been sold as an operating expense, it overstates operating expense while understating cost of goods sold. Finally by recording a sales return as an operating expense, it overstates sales and overstates operating expenses. All of these adjustments were designed to boost gross profit in order to increase the bonus of the CEO.
If we reverse the adjustments made, we get:
2018 Draft | Adjustments | 2018 Revised | |
Net sales | $113,000 | $(7,000) (6,000) | $100,000 |
Cost of goods sold | 62,000 | 5,000 (7,000) | 60,000 |
Gross profit | 51,000 | (11,000) | 40,000 |
Operating expenses | 21,000 | (6,000) (5,000) | 10,000 |
Income from operations | 30,000 | 0 | 30,000 |
Income tax expense | 9,000 | 0 | 9,000 |
Net income | $ 21,000 | $ 0 | $ 21,000 |
Gross profit margin: $51,000÷$113,000 | 45.1% | ||
Gross profit margin:$40,000÷$100,000 | 40.0% |
When we calculate the gross profit margin using the revised amounts, we can see that it has not risen by more than 3% compared to the prior year of 40% ($32,000 ÷ $80,000) and because of this, the CEO will not eligible for his bonus.