Question

E Glenn's Cleaning Services Company is experiencing cash flow problems and needs a loan. Glenn has a friend who is willing to lend him the money he needs provided she can be convinced that he will be able to repay the debt. Glenn has assured his friend that his business is viable, but his friend has asked to see the company's financial statements. Glenn's accountant produced the following financial statements: Income Statement Service Revenue $ 38,000 Operating Expenses (70,000) Net Loss $(32,000) $85,000 $35,000 Balance Sheet Assets Liabilities Stockholders' Equity Common Stock Retained Eamings Total Liabilities and Stockholders' Equity 82,000 32,000 $85,000 Glenn made the following adjustments to these statements before showing them to his friend. He recorded $82,000 of revenue on account from Barrymore Manufacturing Company for a contract to clean its headquarters office building that was still being negotiated for the next month. Barrymore had scheduled a meeting to sign a contract the following week, so Glenn was sure that he would get the job. Barrymore was a reputable company, and Glenn was confident that he could ultimately collect the $82,000. Also, he subtracted $30,000 of accrued salaries expense and the corresponding liability. He reasoned that since he had not paid the employees, he had not incurred any expense. Required 1. Reconstruct the income statement and balance sheet as they would appear after Glenn's adjustments. Comment on the accuracy of the adjusted financial statements. 2. Suppose you are Glenn and the $30,000 you owe your employees is due next week. If you are unable to pay them, they will quit and the business will go bankrupt. You are sure you will be able to repay your friend when your employees perform the $82,000 of services for Barrymore and you collect the cash. However, your friend is risk averse and is not likely to make the loan based on the financial statements your accountant prepared. Would you make the changes that Glenn made to get the loan and thereby save your company? Defend your position with a rational explanation meaning don't just give me your opinon but apply what you have learned about GAAP. 3. Discuss the elements of the fraud triangle as they apply to Glenn's decision to change the financial statements to reflect more favorable results.

Answer 1

Solution to point 1
Reconstructed Income statement

Income Statement
Service revenue	120000
	(38000+82000)
Operating expenses	-40000
	(70000-30000)
Net Profit	80000

Reconstructed Balance Sheet

Balance Sheet
Assets	167000
	(85000+82000)
Liabilities	5000
	(35000-30000)
Stockholders Equity
Common Stock	82000
Retained Earnings	80000
Total Liabilities and Stockholders equity	167000

Solution to point 2

Adjustment 1: Recognition of Revenue even when the contract has not yet been received
GAAP requires that the following conditions be satisfied before the revenue is recorded in the book:
a. there must have been a critical event that triggered the transaction
b. the amount to be collected from the transaction must be measurable reliably

In the given scenario, the contract itself with Barrymore Manufacturing company has not been signed. Therefore, it is not eligible to be recognized in the books. Hence, I Glenn, would not record this adjustment in the books

Adjustment 2: Accrued Salary expense adjustment
GAAP states that you record revenues and all related expenses in the accounting period in which they occur, whether or not there is an actual movement of funds.
As Accrued salary expense represents the salary earned by the employees but not yet due, the same is required to be accrued in the books.
The explanation that as the same is not yet paid, no expense is incurred, is against the principles of GAAP.
Therefore, I Glenn, would not adjust the books to remove the accrued salary expenses.

Solution to point 3

The three elements of the Fraud Triangle are:
a. Opportunity,
b. Pressure (also known as incentive or motivation), and
c. Rationalization (sometimes called justification or attitude)
For fraud to occur, all three elements must be present.

In the case of Glenn, as he is himself the owner of the business, he has the opportunity to make adjustments in the books, thereby committing fraud.
Further, as he is on the verge of bankruptcy, he is under pressure to make adjustments in the books, thereby committing fraud.
Furthermore, Glenn is aware that he will be able to make all his ends meet once he has the loan in his hand and the contract from Barrymore is secured. Therefore, he has a justification to make adjustments in the books, thereby committing fraud.