Question

Imagine you are the head accountant for GE Corp located in Wisconsin. In November 2017, that state had the second highest unemployment rate in the Midwest: 4.9% (down from 6.1% in January 2015). For the past few years, you have noticed that the company’s bad debt rate has been about 7% of year-end accounts receivable. That rate of bad debts has severely affected the company’s profitability…especially since management has steadily been lowering the standards for granting credit to customers.

Your salary structure (as well as that of other corporate managers) allows for a bonus when net income is equal to or greater than a specific percentage of net sales. Unfortunately, that profit metric has not been reached in four years. However, the CEO and CFO (who is retiring after the first quarter of 2018) realized that a change in the bad debts percentage would allow them and you to obtain bonuses in 2017. If bad debts were computed at 2% of year-end A/R rather than 7%, everyone would receive a reasonable (but not extreme) bonus for 2017. The CEO justifies the use of that rate by concluding that, since unemployment in Illinois has been decreasing over the past few years, so will bad debts.

a.   Is a change in a bad debts estimate permissible under generally accepted accounting principles? If yes, explain how such a change is effected. If no, explain why such a change would not be allowed

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

c.   Provide at least two alternatives to help improve the company’s profit performance.

d.   You have a new baby at home as of September 2017. The bonus would help with the added expenses. Additionally, you are up for promotion to CFO next year upon the retirement of the current CFO; allowing the current CEO and CFO to receive their bonuses would certainly bring positive recommendations for that new position.

      1.   Is reducing the bad debts estimate illegal? Explain.

      2.   Is reducing the bad debts estimate unethical, given the CEO’s justification? Explain.

e.   Assume that the CEO and CFO are very adamant that the bad debts percentage be reduced in 2017 to 2% of year-end receivables. The 5% difference is not material to the financial statements. You believe that you will be terminated if you don’t make this adjustment. What should you consider in making your decision?

Answer 1

a. General Electric is a company that is in business to business, they generally dont deal with the common people. However since there is lower unemployment rate in recent past in the town. It is safe to assume that new investments are pouring in and giving the new areas of investments. This may create new ventures for contractos for GE also and less bad debts due to reviting economy.

A change in accounting estimate is allowed when uncertainties are resolved as new events occur, more experience is acquired, or as new information is obtained. The recent reports can be claimed as the sound base for the investment.

However, it may not be as good as to reduce the bad debts estimate to straight 2% from 7%. Thus, in this case it may not be allowed to reduce the estimate. If credible, further reduction of 2% can be made to 4% of A/R

b. Yes, it will violate principle of conservatism which says that an accounting should record expenses and liabilities as soon as possible, but to record revenues and assets only when you are sure that they will occur. It shall also affect Consistency Princple which says that an accounting principle or method should not be change untill a better principle or method comes or situation demands.

c. Company can monitor better and have lesser AR at year end to subsequently reduce bad debt estimate also. They can further increase their sales and engage a bad debt recovery agency to recover their debt. They may also opt fro factoring. These measures will reduce A/R and improve profit by reducing bad debts expenses

d. As per the SEC and SOX Act, disclosures should be made before any change in accounting estimate. Making dubious changes will affect the financial report and will lead to legal consequences for modifying the financial statements. Thus such act would be illegal under SEC and SOX Act.

It will also be unethical as there is no credible basis upon which the change would be effected. The change will show better profits to the investors which may not be true. It may come back hard later on when bad debts actually gets incurred. Thus such practice is unethical on part of cheating with investors and other stakeholders

d. I should consider giving my lettter of recomendation in writing to not reduce the estimate by 5% but by 2 - 3% only in writing. I should also place the facts before audit and remuneration committee. In case nothing happens, I may act as whistle blower and resign