Paul Simon is a new assistant controller at Central Mechanical, a large regional construction company. Before Paul’s recruitment, he was aware of Central’s long trend of moderate profitability. The reports on his desk confirm the slight, but steady improvements in net income in recent years. The issue he is facing as he reviews the reports is the decline and erratic trend in cash flows from operations.

Paul sketched the following comparison ($ in millions):

His sketch shows increasing profits but an ominous trend in cash flow, which is consistently lower than net income. Upon closer review, Ben noticed three events in the last two years that, unfortunately, seemed related:

1. Central Mechanical loosened its credit policy. In other words, Central relaxed its credit terms and lengthened payment periods.
2. Accounts receivable balances increased dramatically.
3. Several of the company’s compensation arrangements, including that of the controller and the company president, were based on reported net income.

What is so ominous about the combination of events Paul sees? If you were Paul, what course of action will you take?

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