A Hypothetical Case on Accounting Malpractices

Introduction
This case gives the information about a Manufacturing company named ABC. The company
followed aggressive accounting practices and had misstated its Income statement and Balance
sheet for the years 1997 & 1998. This case contains all the detailed information considered for
preparing its Income Statement and Balance sheet.

Your Role
This case contains the misstated Income Statement and Balance sheet. Go through the
information provided in the case and Re-state the Income statement and Balance sheet with your
best judgement. If in any situation, you feel that the data is insufficient, consider a suitable
assumption and mention the same in your analysis along with your arguments. Irrelevant or
unnecessary assumptions may attract penalty.
_____________________________________________________________________________________

ABC is a manufacturing company. It has 3 Distributors (X, Y, and Z) across the country. The business runs
on the basis that each Distributor has one warehouse controlled by the company. When the Distributor
finalizes the sale, he gets the product from the warehouse and delivers it to the customer. Distributors
keep track of the inventory and update it on real time basis so as to place the order regularly. Upon receipt
of the shipment, the distributor has a right to return the product back to the Central Warehouse within
15 days of receipt if the product does not meet the market standards. ABC follows calendar year for
accounting purposes i.e. Reporting date is Dec 31 each year. The company follows a shift basis (24 hours)
and works for the whole year. The selling price per unit of the product is $20.

The distributors are essentially the full time employees of the company. He places an order only when the
inventory level touches 40 units and it takes around 5 days for the distributor to receive the products from
the company. The pipeline inventory* is also factored while determining the available quantity for
*pipeline inventory The order once placed with the company adds to the inventory of the Distributor and it is called pipeline inventory and
becomes actual inventory only upon receiving and accepting the products.

consumption. For e.g. if an order is placed on Jan 1 for 10 units and second order is placed on Jan 11 for
25 units; the consumption rate for the intermittent period would be 10 units / 10 days = 1 unit/day.
Therefore, the inventory position as on Jan 6 would be 40+10-(5*1) = 45 units. Both, as on Jan 1 and Jan
10, the inventory position is 40 units.

The orders received by ABC during the years 1997 and 1998 are as follows:
Date
5-Jan-97
1-Feb-97
28-Feb-97
27-Mar-97
23-Apr-97
20-May-97
16-Jun-97
13-Jul-97
9-Aug-97
5-Sep-97
2-Oct-97
29-Oct-97
25-Nov-97
19-Dec-97
12-Jan-98
2-Feb-98
23-Feb-98
16-Mar-98
6-Apr-98
27-Apr-98
18-May-98
8-Jun-98
29-Jun-98
20-Jul-98
10-Aug-98
31-Aug-98
21-Sep-98
12-Oct-98
2-Nov-98
23-Nov-98
14-Dec-98
30-Jan-99

Distributor
X
Y
Z
X
X
Y
Z
Y
X
Y
Z
Y
X
Z
X
Y
Y
Z
X
Z
X
Y
Z
Y
X
Z
Y
Z
Y
X
Y
X,Y,Z

Units
100
120
100
100
100
100
90
100
105
100
100
100
100
140
100
100
140
110
100
100
130
115
150
100
160
100
130
120
120
130
110
50 each

Case Prepared by Prof. Vishwanathan Iyer & R.S.S.S. Pavan Kumar

For manufacturing each unit of this product, the inputs required are 1 standard unit each of steel and
copper which were supplied at $2.4 and $5.6 since the inception of company (Jan 1, 1993) to the end of
March 1998. The company tied up with a transporter for a fee of 0.25% of the value of purchases as
charges for the delivery of the Raw material. Post March 31, 1998; the price of the raw material increased
by 30%. The company purchases all its Raw material on credit basis and enjoys a credit period of 2 months
from its suppliers.

To avoid stock out situations, as well as to factor in any sudden spurt in demand; the company always
holds an additional 90 units of the finished product as inventory at its factory premises. All retailers
communicate their requirements 1 month ahead to their distributor. On the same day, the company
places the order for raw material. The suppliers of raw material are located in close proximity and
therefore deliver the material within 12 hours of order. Direct Labor for the company is available at $ 4
for every 8 hours. There are four processes that a product goes through before it reaches the stage where
it is ready for sale. Process 1, 2, 3 and 4 takes 1 hour, 0.5 hour, 1 hour and 0.5 hour respectively. Factory
overheads are absorbed at 100% of the direct labor. The salaries of all the employees (including
distributors) were increased by 15% flat effective from 1- Jan-1998.

The companys revenue includes the interest earned through their financing activities during the year, as
the company believes that it is part of their business to support their retailers. The company offers an
average credit period of 1 month to all of its retailers. A few of the retailers (Bulk retailers) tend to demand
a 6 month credit period. As the company was still in its initial stages, it accepted the demands of retailers
under the terms that the retailers pay an interest on the amount borrowed beyond the usual credit period
at the market rate i.e. 8% per annum. This is event happens once every year and the quantum of sales is
just 5% of the total sales during 1997 and 15% of the total sales during 1998. The payment for the same
has not been made by the end of the concerned period.

Selling the products of ABC is not an easy process and involves a lot of administrative and selling expenses.
The distributors have to reach out to several retailers to sell the products and that usually involves a lot
of travel expenses. On an average a distributor had to travel 50 kms for selling 1 unit of the product.
Generally, the company has policies to pay for stay only if the distance exceeds 350 km from the city of
origin. The fuel charges for their travel are reimbursed at actuals. The orders from each retailer varies
Case Prepared by Prof. Vishwanathan Iyer & R.S.S.S. Pavan Kumar

from 5 to 9 units. During 1997 there were a total of 178 retailers, 29.2% of the retailers order in group of
7 units, 22.5% of the retailers order in group of 6 units, 20.2% of the retailers order in group of 5 units,
16.85% of the retailers order in group of 8 units and 11.25% of the retailers order in group of 9 units. The
company is yet to approve the bills submitted during the month of December 1997 and same is not
considered in expenses. In any given year, the spread of the retailers is observed to be even across all the
months. During the year 1998, the number of retailers ordering in 7s increased by 44.2%, 6s increased
by 47.5%, 5s increased by 47.2%, 8s increased by 46.67% and 9s increased by 20%. All distributors travel
by bikes and the mileage is considered as 100 km/litre. The fuel cost is considered as $ 3 per litre. The cost
of stay at all the locations remains same at $ 2 per day.

The company enjoyed tax holiday till Dec 31, 1996 and was subjected to regular taxation of 30% corporate
tax from 1997. The company believes in ploughing the net earnings back and therefore did not pay any
dividends.

The company follows a consistent cash management policy of maintaining a cash balance of 3% of revenue
in the current account and transferring the rest of the available cash into Fixed Deposit (FDs). The
company follows First in First out method of inventory Valuation. The company also has strict policies in
holding inventory and it should never cross 90 units. Hence the company plans production in such a way
that it produces the additional units just before the order placement date.

As on Dec 31, 1996, the Ordinary Share Capital of the company stood at $6,000 (1200 share with a face
value of $5) along with an additional paid in capital of 9000 and retained earnings of 6000. The company
issued Zero Coupon bonds with an embedded interest rate of 10% on 1st Jan 1996. The Face Value of the
Bonds was $5500.

The company undertakes a major furnace relining every 5 years at a cost of $2000. The salvage value for
the asset is nil. As on Dec 31, 1996 the net book values of the plant and machinery is $10000, Land $5200,
Vehicles $2000 and Furniture $1000. All these assets were acquired during the inception of the company
and have no salvage value. Due to the advancements in technology, a part of the plant and machinery

Case Prepared by Prof. Vishwanathan Iyer & R.S.S.S. Pavan Kumar

having a net book value of $2000 on Dec 31, 1997 was rendered obsolete. However the net realizable
value in the market for the same is at $1500.

Basis for Depreciation and Amortization: Depreciation is provided on a straight line basis over the useful
lives of assets. The following were considered as reference for calculation of depreciation
1.
2.
3.
4.
5.

Plant and Machinery 20 years

Buildings 30 years
Vehicles 10 years
Furniture, Fixtures and Office Equipments 5 years
Major furnace relining expenses are depreciated over a period of 5 years

ABC Corporation, Income Statement

Description

1997

1998

Revenues

29138

40476

COGS

16034

27439

Gross Profit

13104

13037

Sales and General Expenses

1595

2779

Depreciation

2390

1390

Salaries

1800

2070

Profit Before Tax

9119

8869

Tax

2736

2661

PAT

6383

6208

Case Prepared by Prof. Vishwanathan Iyer & R.S.S.S. Pavan Kumar

ABC Corporation, Balance Sheet

Assets
1997

1998

Cash

874

1214

Cash Equivalents (FD's)

6236

6997

Inventory

1794

2813

Receivables

10006

14194

Property, Plant and Equipment

16550

17160

Total Assets

35459

42378

Borrowings

3415

3415

Payables

1925

2711

Provision for Tax

2736

2661

Share Capital

6000

6000

Additional Paid in Capital

9000

9000

Retained Earnings

12383

18591

Total Liabilities

35459

42378

Liabilities

Case Prepared by Prof. Vishwanathan Iyer & R.S.S.S. Pavan Kumar