Recently newspapers carried stories about a company that fired three top executives for management fraud. The three had been using improper accounting practices to overstate profits. The improper practices included improperly recording assets on the company's balance sheet, overstating sales, and understating cost of goods sold by inflating inventory numbers. When inventory got out of line, the executives would debit property, plant, and equipment and credit inventory to further hide their fraud.

The company had been growing at a very rapid pace, outdistancing its competitors.

However, there were warning signals or "red flags" that revealed that all was not well with the company and that suggested that the books might have been "cooked" in order to report the rapid growth. For example, sales, which were almost all on credit, grew much faster than did accounts receivable when these balances on the company's financial statements were compared with industry data. Inventory turnover was lower than that of competitors while sales were unusually low relative to property, plant, and equipment. A final "red flag" was that management bonuses were tied to sales increases.

Required

1. Which items would be misstated in a horizontal analysis of the company's income statement? Which items would be misstated in a horizontal analysis of the company's balance sheet? Indicate the direction of the misstatement.

2. Why do you think the issue of management bonuses is considered a "red flag"?