Design Incorporated experienced a downturn in December sales. To make matters worse, many of the recent sales were on account and because many customers were not paying on their accounts, the ending balance of Accounts Receivable at December 31 was higher than the beginning balance. Because the business had a dramatic need for cash, a prime piece of land owned by the company was sold for cash in December at a substantial gain. Design had purchased the land 10 years earlier and properly classified it as a long-term investment. The CEO, Jim Shady, was looking over the financial statements and saw the company’s weak operating cash flows. He approached the accountant to ask why the December cash flows provided from operations were so weak, given that the land had been sold. The accountant explained that because the indirect method was used in preparing the cash flow statement, certain adjustments to net income were required. To begin with, the increase in accounts receivable was a decreasing adjustment made in arriving at the net cash provided from operating activities. Next, the large gain recognized on the sale of land had to be adjusted by subtracting it from the net income in arriving at the cash provided by operating activities. These large negative adjustments drastically reduced the reported cash provided from that category of cash flows. The accountant then explained that all the cash proceeds from the land sale were included as cash inflows in the investing activities section.
Jim became worried because he remembered the bank telling him about the importance of strong operating cash flows, so he told the accountant to redo the statement but not to reduce the net income by the accounts receivable increase or the gain on the land sale. The accountant refused because these adjustments were necessary in order to properly arrive at the net cash provided from operating activities. If these adjustments were not made, then the net change in cash could not be reconciled. Jim finally agreed but then told the accountant to just include the cash proceeds from the sale of land in the operating activities rather than in the investing activities. The accountant said that would be wrong. Besides, everyone would know that proceeds from the sale of land should be an investing activity. Jim then suggested listing it as “other” in the operating section so no one would ever know that it wasn’t an operating cash flow.
Why didn’t Jim want the accountant to decrease the net income by the increase in accounts receivable and the gain on the land sale? Why do you think Jim finally agreed with the accountant? Could the operating cash flows be increased by including the cash proceeds from the sale but listing them as “other” rather than as land sale proceeds? What ethical concerns are involved? Do you have any other thoughts?