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Scenario 1: I think Lily’s board will choose a 4% estimate for bad debt expense. Earnings are high this year, so choosing the higher of the two choices (4% vs. 1%) of bad debt expense won’t be as harmful to earnings, on a percentage basis, versus if earnings had been low. Choosing the 4% will enable Lily Company to “load up the cookie jar” (as the title of this case suggests) so that if the indicated “unsettled business conditions ahead” materialize, earnings can be smoothed later since bad debt expense in the “bad” years can be made lower than it otherwise would have been.

Scenario 2: I think Lily’s board will choose a 1% estimate for bad debt expense. Since earnings are already quite low, the board will want to show as high a net income as possible, and this can be done, in part, by choosing the lower bad debt expense estimate. Since the board has reason to believe Lily Company’s operating performance will be better next year, choosing the lower bad debt expense shouldn’t adversely affect future years’ net income in a material way.

The main risk to Lily Company if the bad debt estimate is chosen using only the type of information given here is that financial statements may not accurately represent the company’s financials since cookie jar reserves are being used to smooth earnings over time. This can result in worse opinions of the company by potential investors as well as regulators

Answer 1

The above scenario is a common scenario seen in corporate world. During years when the business is good, entities tend to pile up provisions on the liability side, citing various reasons and justifications, which may include aggressive bad debt provisions, bonus provisions and provisions for fees like legal fees etc.

The only intent, as mentioned in the question, is to ensure that profits are smoothened out, on a year to year basis, by releasing/reversing these provisions in years where business is not good and/or the company incurs some unusual and extraordinary expenses. Provision reversals thus help companies to offsett the impact of these expenses/bad business and still show a better results. This primarily results in an ethical as well as accounting issue. Both these aspects are briefly discussed below:

1. Accounting issue:

As per accounting requirements, provisions can be created only when the entity has present obligations arising out of past events. These include areaas where entities are required to make estimated. When accoutning estimates like bad debt provision, bonus provisions etc fluctuate significantly, depending on the reserves of the the company, the assumptions on which these liabilities were estimated and recorded becomes questionable.Such concerns are typically raised by auditors, who would be expected to test assumptions taken by the entity while creating such provisions

2. Ethical issue

Apart from an accounting issue, such window dressing of books clearly is an ethical issue. The management is trying to manipulate the books of accounts by creation of liablities which do not exist. The accounts, therefore, can be considered to be misleading, both, in the years where profits were high, and therefore, expense provisions were higher, or a situation where the business was bad, and therefore expese provisions were released and due to this reason, the entity definitely faces a reputational risk, if such shady accounting practices were to come tom light of stakeholders

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