Question

Exeter is a building contractor on the Gulf Coast. After losing a number of big lawsuits, it was facing its first annual net loss as the end of the year approached. The owner, Hank Snow, was under intense pressure from the company’s creditors to report positive net income for the year. However, he knew that the controller, Alice Li, had arranged a short-term bank loan of $10,000 to cover a temporary shortfall of cash. He told Li to record the incoming cash as “construction revenue” instead of a loan. That would nudge the company’s income into positive territory for the year, and then, he said, the entry could be corrected in January when the loan was repaid. Requirements 1. How would this action affect the year-end income statement? How would it affect the year-end balance sheet? 2. If you were one of the company’s creditors, how would this fraudulent action affect you?

Short answer

The action will overstate net income and stockholders’ equity, and will understate total liabilities.

Step-by-step solution

Step-by-Step SolutionStep 1: Effect on Income Statement

As the loan amount is reported as construction revenue, it will increase the overall profit of the company, hence it will result in overstatement of net income at the end of the year.

Effect on Balance Sheet

As net income is increased by this action, it will overstate the stockholders’ equity also. Also, as the proceeds should be recorded as liability, which is not recorded in this case, it will understate the liabilities in the balance sheet.