Bud Conn and Salvador Cruz were best friends at a small college, and they fought side-by-side in Iraq. After their military service, they went their separate ways to pursue MBA degrees, Bud to a prestigious East Coast business school and Salvador to an equally prestigious West Coast school. Nearly 20 years later, their paths crossed again.

By 2006, Salvador had become president and CEO of Quantum Electronics after 13 years with the firm. Bud had started out working for Delta Airlines , but left after 7 years to start his own firm, Conn Transport. In April 2009, Conn Transport was near bankruptcy when Bud approached his old friend for help. Salvador answered his friend’s call, and Quantum Electronics bought 19% of Conn Transport. In 2012, Conn was financially stable, and Quantum was struggling. Salvador Cruz thought his job as CEO might be in jeopardy if Quantum did not report income up to expectations. Late in 2012, Salvador approached Bud with a request—quadruple Conn’s dividends so that Quantum could recognize $760,000 of investment income. Quantum had listed its investment in Conn as an available-for-sale security, so changes in the market value of Conn were recorded directly in stockholders’ equity. However, dividends received were recognized in Quantum’s income statement. Although Conn had never paid dividends of more than 25% of net income, and it had plenty of uses for excess cash, Bud felt a deep obligation to Salvador. Thus, he agreed to a $4 million dividend on net income of $4.17 million.

1. Why does the dividend policy of Conn Transport affect the income of Quantum Electronics? Is this consistent with the intent of the accounting principles relating to the market value and equity methods for intercorporate investments? Explain.

2. Comment on the ethical issues in the arrangements between Bud Conn and Salvador Cruz.