John Young is a new assistant controller at Richmond Electronics, a large regional consumer electronics chain. Before John's recruitment, he was aware of Richmond's long trend of moderate profitability. The reports on his desk confirm the slight, but steady, improvements in net income in recent years. The issue he is facing as he reviews the reports is the decline and erratic trend in cash flows from operations.
John sketched the following comparison ($ in millions):
2014 2013 2012 2011
Income from operations $ 140.0 $ 132.0 $ 127.5 $ 127.0
Net income 38.5 35.0 34.5 29.5
Cash flow from operations 1.6 19.0 14.0 15.5
His sketch shows increasing profits but an ominous trend in cash flow, which is consistently lower than net income. Upon closer review, Ben noticed three events in the last two years that, unfortunately, seemed related:
1. Richmond loosened its credit policy. In other words, Richmond relaxed its credit terms and lengthened payment periods.
2. Accounts receivable balances increased dramatically.
3. Several of the company's compensation arrangements, including that of the controller and the company president, were based on reported net income.
What is so ominous about the combination of events John sees? If you were John, what course of action will you take?
As sales have increased and net income has increased, both in nominal terms and as a percentage of net income, cash flow has decreased dramatically between 2011 and 2014, but especially between 2013 and 2014. This tells me that the company is not properly recording the bad debts expense but has sold a lot of goods that it will ultimately not be paid for. The company has set up a situation where the best interests of its executives does not align with that of the company as a whole. Instead, the executives have a vested interest in increasing sales and not recording expenses in order to increase net income, which is the basis upon which they are compensated. Loosening the company's credit ...
This solution discusses the inevitable conflicts between the best interests of a company and those of its executives when it crafts a compensation package based upon accrual-basis measures rather than on cash-basis measures of performance.