Question

Sky-High, Inc. pays company management bonuses at the end of each year if net income is equal to or greater than a specific percentage of net sales. However, in the past five years, that metric has not been reached. During these past five years, Sky-High has been lowering the requirements for granting credit to customers so that more sales can be generated. However, making those credit changes has caused the company’s uncollectible accounts percentage to rise substantially; for last year, it was 8.5% of the year’s net sales.

Before the past five years, Sky-High had been estimating uncollectible accounts at 3% of net sales. That rate had been effective in that no material adjustments needed to be made at any year-end. The CEO has asked you (the company accountant) to return to using that 3% percentage. His rationale is that the economy is strengthening and so uncollectible accounts should begin to decrease. If the 3% is used, all company management will receive a small bonus for this first time in five years.

a.   A change in the estimate of uncollectible accounts is allowed under generally accepted accounting principles. How would such a change be accounted for?

b.   Would making such a change in the uncollectible accounts estimate violate any basic accounting concepts? Explain your yes or no answer.

c.   Provide three alternatives related to accounts receivable that might help improve the company’s profit performance.

d.   If the company uses a 3% estimate for uncollectible accounts (rather than a more appropriate, higher percentage), the difference is notmaterial to the financial statements. The CFO will be retiring next year and you are the “first choice” for the promotion. If you don’t make the adjustment, you could be seen as insubordinate and be fired. The bonus you would receive this year would help in paying off your student loans. What should you consider in making your decision?

Answer 1

a. It should be noted that a change in accounting estimate is needed if there has been a change affecting the carrying value of assets or liabilities or there has been identification of any new information that alters the existing situation.

If there is any change in accounting estimate, then it should be accounted in the period of change itself. However, if change will also impact future periods, then it will also likely to have an accounting impact in future periods also.

It should be noted that change in accounting estimate do not require restatement of financial statements.

Further it should be noted that if change is likely to have immaterial effects on financial statements then it's disclosure is not necessary.

In the present case, company should create provision with 8.5% and should also disclose it.

b. As per accounting concept of consistency an accounting policy or estimate should be followed consistently from one period to another. However, if any change is required by law or accounting standards or such change will lead to true and fair presentation then such change is allowed and do not violate the concept of consistency.

In the present case also change in accounting estimate for uncollectible amounts will lead to true and dair presentation and thus do not violate any any accounting concept.

c. Alternatives relating to accounts receivable that may improve company's profit performance are :-

1 . Cash discount = company may encourage debtors to make prompt payment by giving them Cash discount this will encourage them to make payment and get discount which will ultimately reduce uncollectible amount and improve profit performance of the company.

2. Ageing of debtors = By preparing are schedule of debtors it will identify debtors from whom money is due from a longer period and can make efforts to collect it.

3. Use of factoring = factoring arrangement allows company to sell it's debtors to factors at a nominal discount and fees, afterwards risk relating tiv bad debt will be of factors and company can focus on other key areas of the business free mindedly.

d . If company uses 3% estimate for uncollectible accounts rather than more appropriate rate of 8.5% even if it may not have material impact on financial statements would lead to violation of accounting concept of true and fair presentation of financial statements and may diminish the brand image of the company which will have adverse impact in the long run. So rather than looking at the short term objective of promotion or bonus focus should be on long term goals and brand building which will ultimately lead to more profit.

Thus, rather than 3% rate for uncollectible amiunt, usage of more appropriate rate of 8.5% is more preferable.considering the current scenario.