Question

Philip Stanton, the executive manager of Thomson Pharmaceutical, receives a bonus if the company’s net income in the current year exceeds net income in the past year. By the end of 2021, it appears that net income for 2021 will easily exceed net income for 2020. Philip has asked Mary Beth Williams, the company’s controller, to try to reduce this year’s income and “bank” some of the profits for future years. Mary Beth suggests that the company’s bad debt expense as a percentage of accounts receivable for 2021 be increased from 10% to 15%. She believes 10% is the more accurate estimate but knows that both the corporation’s internal and external auditors allow some flexibility in estimates. What is the effect of increasing the estimate of bad debts from 10% to 15% of accounts receivable? How does this "bank" income for future years? Why does Mary Beth’s proposal present an ethical dilemma?

Answer 1

a.The adjusting entry for bad debt expense is Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts.

While bad debt expense is a temporary account, closed by transfer to the Income Statement, allowance for doubtful accounts is a contra asset account, deducted from gross accounts receivable to compute net accounts receivable.

The effect of increasing the estimate of bad debts from 10 % to 15 % of accounts receivable would have the effect of increasing bad debt expense and allowance for doubtful debts. This would reduce net income on the one hand, and reduce net accounts receivable on the other.

b. In the future years, the management can assert that the estimate for bad debt in the earlier year was too high, and therefore, reduce the estimate of bad debts for future years, thereby decreasing bad debt expense, and increasing net income. This would also entail reversing the excess in the allowance for doubtful accounts.

Therefore, a part of the net income of the current year can be deferred to future years through the allowance account. This is how a part of the income of the current year can be "banked" for future years.

c. First and foremost, Mary Beth should avoid conflict interest at all cost. She should not compromise on her professional integrity at any cost. While her interest is to keep her job ( plus promotions and higher compensation ) by pleasing her superior, Philip Stanton, the interest of the firm is shareholder wealth maximization. Mary Beth's proposal for banking income for future years is to ensure that Philip will get a steady bonus in future years too. While that will serve Mary Beth's own interest, the interest of the firm and its stockholders would be adversely impacted, since a reduced income for the current year would adversely the net worth of the stockholders.

Secondly, the financial statements ( income statement and balance sheet) are expected to reflect a true and fair view of the operating results ( net income) and the financial position ( assets ) of the business. Mary Beth's proposal not only would have the effect of understating net income, but also would aso result in understating both assets ( net accounts receivable) and stockholders equity ( retained earnings). Based on the distorted picture portrayed by these financial statements, the stakeholders of the firm might end up making incorrect economic decisions.