Question

Question

Assume that you are preparing Galore Ltd's yearly allowance for doubtful debts based on 2% of net credit sales,

which will potentially result in 10% growth rate. The managing director, Ms Sharon Shady (Sharon), suggested you to increase the allowance for doubtful debts to 4% in order to achieve a 5% growth rate. Sharon said to you that: "we do not want our shareholders to expect our company to sustain a 10% growth every year rather, a 5% growth rate is more sustainable for our company."

Question:

Part A

1). What are the relevant factors that should be considered when estimating yearly allowance for doubtful debts?

2). How does the allowance for doubtful debts potentially impact Galore Ltd's financial reports?

Part B

1). a. Is it ethical to follow the managing director, Sharon, to estimate the allowance for doubtful debts based on a predetermined 5% growth rate?

b. Will you follow Sharon's suggestion?

2). How does your decision about whether to follow Sharon's suggestion influence various stakeholders? You are required to provide detailed explanations.

Answer 1

Answer:

The allowance for doubtful accounts represents management’s best estimate of the amount of accounts receivable that will not be paid by customers. If actual experience differs from the expected amount, then management modifies the estimation method so that estimations for allowance are more realistic.

Estimation is made considering factors such as:

1. Risk category of the Customers
2. Pareto Analysis i.e. using statistical methods for high account balance customers and making provisions based on credit ratings and trends
3. Past trend of receipts from Customers

The balance of allowance reserve needs to be revised from time to time such as monthly or quarterly in light of overdue receivables to ensure allowance for doubtful debts is sufficient.

The allowance impacts the Income statement (i.e. Growth rate) by charging the initial bad debts expense.

Case:

PART A (1)

Estimation is made considering factors such as:

1. Risk category of the Customers
2. Pareto Analysis i.e. using statistical methods for high account balance customers and making provisions based on credit ratings and trends
3. Past trend of receipts from Customers.

PART A (2) When Galrore Ltd. charges bad debts to revenue, the profit will reduce by the amount of provision and a corresponding credit would be given to the reserve account created for doubtful allowance which will be a reduction of the total amount of accounts receivable appearing on the balance sheet. This deduction is classified as a contra asset account.

PART B(1)a. Sharon wants to increase the percentage of Doubtful debts so that she can manipulate the net profit and the face growth rate to manipulate the shareholders expectations. The intention is malified and the provision is not made based on the factors to be considered while making the allowance estimations. Her intention in not ethical.

PART B(1)b. Since Sharon’s decision is unethical, I would review the doubtful allowance based on the factors such as past tend etc. and discuss the same with the key managerial personnel.

PART B(2) Following Sharon’s suggestion would impact the statements as below:

1. The expense amount would increase reducing the profit and growth rate.
2. The reserve amount would be higher showing reduced net receivables.

The profit available for distribution to shareholders and funds for reinvestment to increase growth in future would also be less. Shareholders would become bearish on shares as lower expectations would hurt the share value in short run.