Question

Ryan Company has as a goal that its earnings per share should increase by at least 3% each year; this goal has been attained every year over the past decade. As a result, the market price per share of Ryan's common stock also has increased each year. Last year (2015), Ryan's earnings per share was $3. This year, however, is a different story. Because of decreasing sales, preliminary computations at the end of 2016 show that earnings per share will be only $2.99 per share. You are the accountant for Ryan. Ryan's controller, Jim Nastic, has come to you with some suggestions. He says, “I've noticed that the decrease in revenues has been primarily related to credit sales. Since we have fewer credit sales, I believe we are justified in reducing our bad debts expense from 4% to 2% of net sales. I also think that because of the decreased sales, we won't use our factory equipment as much, so we can extend its estimated remaining life from 10 to 15 years for computing our straight-line depreciation expense. Based on my calculations, if we make these changes, Ryan's 2016 earnings per share will be $3.06. This will sure make our shareholders happy, not to mention our CEO. You may even get a promotion. What do you think?”

Required:

From financial reporting and ethical perspectives, prepare a response to Jim regarding his suggestions.

Answer 1

Accounting estimates has become a contentious topic - for auditors, regulators, corporations and investors. As far as investors are concerned, financial information has to be current and relevant and useful. Accounting Standards Codification (ASC) 250-10-50-4 mandates that "companies disclose the nature and effect of any change in estimate that has a material impact on the company's financial statements".

A change in accounting estimates, however, cannot be driven by the need to maintain growth in profits and earnings per share (EPS). Ryan corporation has been able to maintain a fixed a target growth rate of 3% every year. In the previous year, the company declared an Earnings per share of $ 3.00. However, due to decreasing sales revenue, the company as per its internal projections, would be able to reach an EPS of $ 2.99 only, instead of $ 3.09.

The Chief Financial Officer's initiatives to change the estimates of Bad Debts and Depreciation are reviewed separately in light of the requirements of USGAAP and the need for members of the American Institute of Certified Public Accountants (AICPA) to comply with the Professional Code of Conduct at all times.

Estimating Bad Debt Expense

As per USGAAP, when a company makes sales to customers on credit, it is required to recognize revenue on its Income Statement, irrespective of whether these credit customers pay their dues on the due date. When these customers are unable to pay their dues, then the company has to report an expense to off-set the revenue recognized earlier at the time of sale. This expense is kown as Bad Debt Expense.

The company cannot, however, wait for each customer account to go bad before reporting as Bad Debt expense. Instead, a bad debt expense is reported based on an estimate arrived at after analyzing Accounts Receivable. The company will never be able to forecast which sales / customer account will go bad, but it is known that a small percentage will go bad. Accordingly, USGAAP recommends that the company's accounts statements reflect this fact.

Prima facie, the Controller is well within his right to make a lower estimate. It is his call, and if he is confident of justifying it, he can authorize the reduction of bad debt expense. The question of ethics arises if the Controller is reducing bad debt expense only to improve profit and EPS growth.  

In this case, it is apparent that the reduction in bad debt expense is simply to show better financial results for the current year. It ignores the fact that sales could improve the next year. In which case, the company may not be able to revise its estimate of bad debt expense once gain.

Increasing the useful life of fixed assets to reduce depreciation and increase profit

Reducing the useful lfe of fixed assets happens to be based on the fact that decreasing sales would lead to factory equipment not being fully utilized in the coming months. Changing the useful life of equipment is again based on an estimate. The change in estimate would result in a decrease in depreciation, and increase profits and Earnings Per Share.

In this case, it is prima facie justifiable for the Chief Financial Officer to change the estimate. However, the fact that the change is merely to maintain the EPS growth seems to run contrary to the AICPA Code of Professional Conduct.

The Responsibility Principle of the AICPA Code of Professional Conduct states that members "should exercise sensitive professional and moral judgements in all their activities, in the process of discharging their responsibilities".

The Public Interest Principle states that "members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate a committment to professionalism".The public relies on the "objectivity and integrity of members to maintain orderly functioning of commerce". While discharging their professional responsibilities, "members may encounter pressures from the public. In resolving the conflicts members are expected to act with integrity, objectivity and due professional care, and a genuine interest in serving the public".

The Integrity principle requires all members to be "honest and candid within the constraints of client confidentiality. Service and public trust should not be subordinated to personal gain and advantage. Integrity can accomodate the inadvertent error and honest difference of opinion. However, it cannot accomodate deceit and subordination of principle".

In the case of Ryan Corporation, the Chief Financial Officer was clearly violating the principles of responsibility, public interest and integrity.

He is not being ethical by changing estimates merely to boost profiits and EPS to accomodate the conflicting pressure of expectations from the management and investors groups of the public.