Question

ily Company has historically reported a bad debt expense amount of between 1% and 4% of sales. The percentage for any given year is a function of both the business conditions for the year and whether recent experience suggests that the estimates in past years have been too high or too low. For example, if estimates in past years have been too high, a lower amount of bad debt expense is recognized in the current year. Lily Company's board of directors has met to review the preliminary financial statements for the just-completed fiscal year. Assume that the board will decide on a bad debt estimate of either 1% or 4% of sales, consider the following two scenarios: Scenario 1. The preliminary earnings number for the year is very high, far higher than expected. However, Lily's board is concerned about future years; there is some indication of unsettled business conditions ahead. Scenario 2. The preliminary earnings number for the year is quite low, lower than expected. The board has reason to be optimistic that Lily's operating performance will turn around next year. What estimate (1% or 4%) do you think Lily's board will choose in each of the two scenarios? Explain your choices. What risks are there to Lily Company if the bad debt estimate is chosen using only the type of information given here?

Answer 1

Scenario 1: In this scenario the bad debt estimate for this year should be 4%. This is because Lily Company, by recognizing a higher bad debt expense this year, will have the flexibility of recognizing lower bad debt expenses in future years when business conditions is expected to become unsettled, thus leading to a fall in earnings in future.

Scenario 2: In this scenario the bad debt estimate for this year should be 1%. This is because earnings number for this year is expected to be low but it is likely to increase in future years. Hence Lily Company will increase its bad debt estimate in future years when earnings will witness a revival in its growth.

Lily Company, by using only the information provided here to estimate its bad debt expenses, runs the risk of either overestimating or underestimating its bad debt expenses. The company has to select from only two percentages – i.e. 1% and 4% and this may not be realistic and accurate in all cases. Instead the company should use a statistical model and should increase the percentage as the age of its receivable increases.