Babbit Corp. is a medium-sized wholesaler of automotive parts. It has 10 stockholders who have been paid a total of $1 million in cash dividends for 8 consecutive years. The board’s policy requires that, for this dividend to be declared, net cash provided by operating activities as reported in Babbit’s current year’s statement of cash flows must exceed $1 million. President and CEO Milton Williams’s job is secure so long as he produces annual operating cash flows to support the usual dividend.
At the end of the current year, controller Jerry Roberts presents president Milton Williams with some disappointing news: The net cash provided by operating activities is calculated by the indirect method to be only $970,000. The president says to Jerry, “We must get that amount above $1 million. Isn’t there some way to increase operating cash flow by another $30,000?” Jerry answers,
“These figures were prepared by my assistant. I’ll go back to my office and see what I can do.” The president replies, “I know you won’t let me down, Jerry.”
Upon close scrutiny of the statement of cash flows, Jerry concludes that he can get the operating cash flows above $1 million by reclassifying a $60,000, 2-year note payable listed in the financing activities section as “Proceeds from bank loan—$60,000.” He will report the note instead as “Increase in payables—$60,000” and treat it as an adjustment of net income in the operating activities section.
He returns to the president, saying, “You can tell the board to declare their usual dividend. Our net cash flow provided by operating activities is $1,030,000.” “Good man, Jerry! I knew I could count on you,” exults the president.
Instructions
(a) Who are the stakeholders in this situation?
(b) Was there anything unethical about the president’s actions? Was there anything unethical about the controller’s actions?
(c) Are the board members or anyone else likely to discover the misclassification?