Sherman Inc. owns 18 percent of the voting shares of Arbor Corporation. The remainder of the Arbor Corporation shares are held by numerous investors with small holdings. Ken Tung, president of Sherman Inc. and a member of Arbor Corporation's Board of Directors, heavily influences Arbor Corporation's policies.
Under the fair-value method of accounting for investments, Sherman Inc.'s net income increases if or when it receives dividends from Arbor Corporation. Sherman Inc. pays Mr. Tung, as president, a bonus computed as a percentage of Sherman Inc.'s net income. Therefore, Tung can control his personal bonus to a certain extent by influencing Arbor Corporation's dividends.
Sherman Inc. has a bad year in 2014, and corporate income is low. Tung uses his power to have Arbor Corporation pay a large cash dividend. This action requires Arbor Corporation to borrow a substantial sum one month later to pay operating costs.
Required
1. In getting Arbor Corporation to pay the large cash dividend, is Tung acting within his authority as a member of the Arbor Corporation Board of Directors? Are Tung's actions ethical? Whom can his actions harm?
2. Discuss how using the equity method of accounting for investments would decrease Tung's potential for manipulating his bonus.