"You can't write up assets," said Nick Toby, internal audit director of Nadir International Inc., to his boss, Jim Majewski, vice-president and chief financial officer. "Nonsense," said Jim, "I can do this as part of a quasi-reorganization of our company." For the last three years, Nadir International, a farm equipment manufacturing firm, has experienced a downturn in its profits as a result of stiff competition with overseas firms and a general downturn in the North American economy. The company is hoping to turn a profit by modernizing its property, plant, and equipment. This will require Nadir International to raise a lot of money. Management is very optimistic as to the future of the company, as the economy is entering a significant growth period. Over the past few months, Jim has tried to raise funds from various financial institutions, but they are unwilling to lend capital. The reason they give is that the company's net book value of fixed assets on the balance sheet, based on historic cost, is not large enough to sustain major funding. Jim attempted to explain to bankers and investors that these assets are more valuable than their recorded amounts, especially since the company used accelerated amortization methods and tended to underestimate the useful lives of assets. Jim also believes that the company's land and buildings are substantially undervalued because of rising real estate prices over the past several years. Jim's proposed solution to raise funds is a simple one: First, declare a large dividend to company shareholders that results in Retained Earnings having a large debit balance. Then, write up the fixed assets of Nadir International to an amount that is equal to the deficit in the Retained Earnings account.
Instructions
Adopt the role of the internal auditor and discuss the financial reporting issues. Nadir is thinking of going public.