1a. You should be able to find five earnings management games played by the son in the case in order to help assure that income was higher in the year he ran the company.

1b. Assume now that you are an investor in Grey Paints and receive audited financial statements with the adjusting journal entries included in #2. You are leery of games being played by the company. What could you do in your analysis to discover each of the other earnings management games played in 2004?

In January 2005, Henry received a conference call from his cousins expressing their serious concern over the sharp reduction in dividends. Dividends had been $280,000 in 2002, and $332,000 in 2003, but plummeted to only $116,000 in 2004. Henry told his cousins that he had expected a decline in net income in 2004, and this decline would explain the dividend reduction. He promised to investigate the matter when he met with his son later in the month. On January 29, Henry met with Jeffrey at the corporate headquarters. Given his expectation of a drop in net income as well as the decline in dividends, he was shocked by Jeffrey's assertion that Grey Paints' performance in 2004 exceeded that of 2003. Jeffrey argued that shareholder value was being enhanced by limiting dividends and retaining cash in the business through investments in assets, namely inventory and equipment. Henry was skeptical. Not being an accountant, he could not be certain whether Jeffrey followed generally accepted accounting principles and made logical, consistent assumptions in the preparation of the 2004 financial statements.

However, based upon his understanding of the business and a reading of the financial statements, Henry had some concerns. He noticed that Jeffrey used straight-line depreciation for the punch press/ welder acquired during 2004. This depreciation method was inconsistent with the method used for all previous asset acquisitions. He wondered why Jeffrey would adopt a different depreciation method and what impact that change had on the 2004 reported net income. Bad debts and sales returns on the 2004 income statement represented only actual bad debts and returns experienced prior to December 31, 2004. Jeffrey had made no provision for possible bad debts or sales returns. He did this because Grey had traditionally used the direct write-off method to account for bad debts, and sales returns had not been an issue in the past. Henry wondered whether possible sales returns should be estimated prior to actual occurrence, especially since sales returns from the new customers were expected to be 5 percent of sales.

Henry noticed that the balance sheet for December 31, 2004 showed a decrease in the land account in the amount of $50,000. The cash flow statement revealed that this land was sold for $100,000; a gain of $50,000. Jeffrey revealed that he sold some excess land located in another state. This land had been held in the family business for many years and had sentimental value attached to it. Henry was upset that his son sold this land, but Jeffrey reminded Henry that no one from the family had even stepped on the land in years. Henry remained upset and wondered whether this gain should be included when determining whether Grey performed as well in 2004 as in 2003. At this point, Henry heard maintenance supervisor Mabel Thom calling him from a nearby office. Out of Jeffrey's earshot, Mabel told Henry that her maintenance budget was decreased by 20 percent (from $40,000 to $32,000 per year) and about a sale Jeffrey booked in 2004 and shipped FOB shipping point on December 31, 2004, which arrived at the customer's warehouse on January 5, 2005. If not for this transaction, the December 31, 2004 ending inventory would have been $20,000 higher and sales $38,000 lower in 2004. Mabel indicated that the goods were finished and boxed by December 26, 2004, but were not shipped on that day due to confusion as to the exact delivery location.

The confusion was not cleared up until December 30th. At that point, the customer decided she would rather have it delivered after January 1, 2005, because she had arranged for a large party to be held in the inventory receiving area on December 31, 2004. For reasons unknown to Mabel, Jeffrey had hired an independent shipping company to make the delivery and had insured the cargo during transit (Grey's fleet insurance routinely covered these deliveries). It was a half-day trip to the customer's warehouse, but Jeffrey loaded the delivery truck with the merchandise on December 31, 2004, and the driver drove the merchandise approximately half-way to the customer's warehouse. Mabel told Henry that Jeffrey paid the driver to stay in a four-star hotel for two nights until January 2, 2005, when the delivery was made in the early morning. The driver had quickly volunteered for the trip, since he was paid time and a half and given a generous meal allowance. After all, it was not every day that he got to stay in a fancy hotel and baby-sit a truckload of wall hangings. Henry deeply regretted agreeing to a contract that did not clearly specify how performance was to be determined. He acknowledged that the net income amounts Jeffrey had calculated for 2004 were greater than the 2003 income.

However, Henry suspected that his son had selected only the income-maximizing accounting treatments. He pointed out that cash flows from operations for 2004 were below that of 2003. Could this mean that Grey, in fact, did not perform as well in 2004? Henry was beginning to question exactly what it means to perform as well and how that can be best measured. Henry did breathe a sigh of relief knowing that the bank required an audit of Grey's 2004 financial statements. Bank policy required all businesses with outstanding loan balances to provide annual audited financial statements within four months after year-end. Jeffrey employed the same audit firm that Henry had used for the past several years.