Question

Scenario:  

Beta Computers is experiencing financial difficulties attributed to declining sales of its mainframe computer systems. Several years ago, the company obtained a large loan from Midland State Bank. The covenants of the loan agreement strictly state that if Beta is unable to maintain a current ratio of 3:1, a quick ratio of 1:1, and a return on assets of 12 percent, the bank will exercise its right to liquidate the company’s assets in settlement of the loan. To monitor Beta’s performance, the bank demands quarterly financial statements that have been reviewed by an independent CPA.

Nick Price, Beta’s CEO, has just reviewed the company’s master budget projections for the first two quarters of the current year. What he has learned is disturbing. If sales trends continue, it appears that Beta will be in violation of its loan covenants by the end of the second quarter. If these projections are correct, the bank might foreclose on the company’s assets. As a consequence, Beta’s 750 employees will join the ranks of the unemployed.

In February of the current year, Rembrant International contacted Beta to inquire about purchasing a custom-configured mainframe computer system. Not only would the sale generate over a million dollars in revenue, it would put Beta back in compliance with its loan covenants. Unfortunately, Rembrant International is an extremely bad credit risk, and the likelihood of collecting on the sale is slim. Nonetheless, Nick Price approved the sale on February 1, which resulted in the recording of a $1.4 million receivable.

On March 31, Edgar Gamm, CPA, arrived at Beta’s headquarters. In Gamm’s opinion, the $1.4 million receivable from Rembrant International should immediately be written off as uncollectible. Of course, if the account is written off, Beta will be in violation of its loan covenants and the bank will soon foreclose. Gamm told Price that it is his professional duty to prevent any material misstatement of the company’s assets.

Price reminded Gamm that if the account is written off, 750 employees will be out of work, and that Gamm’s accounting firm probably could not collect its fee for this engagement. Price then showed Gamm Beta’s master budget for the third and fourth quarters of the current year. The budget indicated a complete turnaround for the company. Gamm suspected, however, that most of the budget’s estimates were overly optimistic.

As an employee, write an internal memo to your manager addressing the following:

Should Gamm insist that the Rembrant International account be classified as uncollectible? Should the optimistic third and fourth quarter master budget projections influence his decision? What would you do if you were in his position? Defend your actions.

If you were the president of Midland State Bank, what would you do if you discovered that the Rembrant International account constituted a large portion of Beta’s reported liquid assets and sales activity for the quarter? How would you react if Edgar Gamm’s accounting firm had permitted Beta to classify the account as collectible?

Answer 1

As per my opinion, Gamm should insist that the Rembrant International account should be classified as uncollectible. As the income is not yet received and the debtor has an extremely bad credit risk, and the likelihood of collecting on the sale is slim. As Gamm is an independent CPA, it’s his responsibility to provide a true and fair picture of the company.

If the amount is shown as collectible then the it would put Beta in compliance with its loan covenants. But this would be wrong on the part of Gamm. The optimistic third and fourth quarter budgets are also been made with keeping that 1.4 Million sale into consideration. Therefore, that will not effect the decision of Gamm.

As the president of Midland State Bank, if it is discovered that the Rembrant International account constituted a large portion of Beta’s reported liquid assets and sales activity for the quarter, can provide some amount of time to Beta Computers to collect the amounted sales and if not then will exercise the right to liquidate the company’s assets in settlement of the loan.

If Edgar Gamm’s accounting firm had permitted Beta to classify the account as collectible, then he will be charged against showing false image of Beta computers.