Question

It is February 16, 2018, and you are auditing Davenport Corporation’s financial statements for 2017 (which will be issued in March 2018). You read in the newspaper that Travis Corporation, a major customer of Davenport, is in financial difficulty. Included in Davenport’s accounts receivable is $50,000 (a material amount) owed to it by Travis. You approach Jim Davenport, president, with this information and suggest that a reduction of accounts receivable and recognition of a loss on doubtful accounts for 2017 might be appropriate. Jim replies, “Why should we make an adjustment? Ted Travis, the president of Travis Company, is a friend of mine; he will find a way to pay us, one way or another. Furthermore, this occurred in 2018, so let’s wait and see what happens; we can always make an adjustment later this year.”

Required: Write a memo:-

In your position as the external auditor of Davenport Corporation, prepare a memo to Jim Davenport and address the following:

1. The ethical issues you both face.
2. The major stakeholders involved and state how the stakeholders would be affected by the course of action suggested by Jim Davenport.
3. Explain why you believe the course of action proposed by Charlie Brown is ethical or unethical.
4. Explain the proper accounting treatment and support your answer with appropriate authoritative citation.

Answer 1

The primary aim of financial reporting is to give a true and fair view of the state of affairs of a company as on the reporting date, and of the operating results of the company for the financial year to the various users of these reports, i.e the stockholders, creditors tax authorities, employees etc.

As per the principles of conservatism and revenue recognition, revenues and assets should be recognized only once they are assured to be realized. In the event that there is any doubt as to their realization, they should be adjusted by recording a loss and a commensurate decrease to the carrying value of the related asset.

If it is being reported in the newspapers that Travis Corporation is in financial difficulty, then it must be very serious, as there can be no smoke without fire. Therefore, an adjustment should be recorded by debiting either Bad Debt Expense / Allowance for Doubtful Accounts and crediting Accounts Receivable by $ 50,000, with a detailed disclosure in the notes to accounts.

If this adjustment is not made to the accounts, both the net income and the asset ( accounts receivable ) would remain overstated, thereby misleading the various stakeholders of the business into making inappropriate economic decisions, and this would be very unethical from the point of view of the management of Davenport Corporation.

It would also be unethical for the auditors to issue a clean report on the financial statements of Davenport Corporation under the circumstances, and therefore if the adjustment is not made as suggested, the auditor should qualify their opinion.