Errors in Financial Statements

The following financial statements are available for Sherwood Real Estate Company:

Balance Sheet
Assets Liabilities
Cash . . . . . . . . . . . . . . $ 1,300 Accounts payable . . . . . . . . $ 100,000
Receivable from sale of
real estate. . . . . . . . . 5,000,000 Mortgage payable. . . . . . . .
Total liabilities . . . . . . . . . . . 6,000,000
$ 6,100,000
Interest receivable*. . . . 180,000
Real estate properties . . 6,000,000
Stockholders' Equity
Capital stock. . . . . . . . . . . . $ 10,000
Retained earnings . . . . . . . . 5,071,300
Total stockholders' equity. . . 5,081,300
Total assets . . . . . . . . . $11,181,300 Total liabilities and
stockholders' equity. . . . . $11,181,300
*Interest Receivable applies to Receivable from sale of real estate.
Income Statement
Gain on sale of real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,200,000
Interest income*. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,380,000
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,180,000
*Interest Income applies to Receivable from sale of real estate.

Sherwood Company is using these financial statements to entice investors to buy stock in the
company. However, a recent FBI investigation revealed that the sale of real estate was a fabricated
transaction with a fictitious company that was recorded to make the financial statements look bet-
ter. The sales price was $5,000,000 with a zero cash down payment and a $5,000,000 receivable.
Prepare financial statements for Sherwood Company showing what its total assets, liabilities, stock-
holders' equity, and income really are with the sale of real estate removed.

Appropriateness of Accounting Rules

In the early 1990s, the top executive of a large oil refining company was convicted of financial state-
ment fraud. One of the issues in the case involved the way the company accounted for its oil inventories. The company would purchase crude oil from exploration companies and then process the
oil into finished oil products, like jet fuel or diesel fuel. Because there was a ready market for these finished products, as soon as the company purchased the crude oil, it would value its oil inventory at the selling prices of the finished products less the cost to refine the oil. This type of accounting was questioned because it allowed the company to recognize profit before the actual sale (and even
refining) of the oil. Nevertheless, one of the large CPA firms attested to the use of this method.

If you were the judge in this case, would you be critical of this accounting practice?