Question

Peter Parker was the accounting manager at Zelco, a tire manufacturer, and he played golf with Bruce Banner, the CEO, who was something of a celebrity in the community. The CEO stood to earn a substantial bonus if Zelco increased net income by the end of the year. Parker was eager to get into Banner's elite social circle; he boasted to Banner that he knew some accounting tricks that could increase company income by simply revising a few journal entries for rental payments on storage units. At the end of the year, Parker changed the debits from "rent expense" to "prepaid rent" on several entries. Later, Banner got his bonus, and the deviations were never discovered.

1. How did the change in journal entries affect the net income of the company at year-end?
2. Who gained and who lost as a result of these actions?

Answer 1

Net Income = Revenues - Expenses

Net income can be increased by either increasing revenues, or by decreasing expenses, or by both.

By changing the debits from Rent Expense to Prepaid Rent, a part of expenses were deferred to the next accounting period, thereby reducing expense for the current accounting period. Reduction in current year expense led to increase in net income of the company.

As a result of these actions, Bruce Banner earned his desired bonus, and Peter Parker too must have gained in terms of a pay hike or a promotion.

The users of the financial statements however lost, as they were entitled to a true and fair view of the operating results of the company, and its financial position, but were deprived therefrom.