Question

Case 23.2 – An Ethical Dilemma 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.

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

Explanatio

Part 1 - Dilemma of CPA Gamm

As a CPA, It is the professional duty of gamm to give true and fair report to stakeholders.

Gamm, on the basis of his professional judgement and professional skepticism and by analysing other facts and review of account, concluded that account of Rembrant International is uncollectible.

Hence Gamm should make qualification in his report. It is not CPA job to shadow the client fading business to attract bank and investors.

Overly optimistic budgets are baseless and are based on false evidences of forecasting. Gamm as a professional accountant caught the overly optimistic Budget. Such budget will also not be able to influence the decision regarding qualification in report.

Most likely way to sort things out is Nick and gamm should meet president of bank to get any solution, bank can provide. In most of the cases, bank also cooperate with businessman to get the solution since they are customers of bank.

If i were the CPA Gamm, then as a professional accountant, it is my duty to follow all code of conduct and audit standards and Also a meeting can be done with president of bank and Nick for a any solution.

Part 2 - Actions as president of Midland State Bank

As a president of Midland state bank, it is my duty to study the quarterly statements and any budgets and projections report submitted by Beta Computers.

After analysing that, Most of liquid assets and sales relate to Rembrant International and CPA's classification shows it as collectible, then it will my professional duty to discuss the matter with Beta computers and analyse the budget and projections excluding the data relating to rembrant international.

If such further analysis shows that such accounta can become uncollectible and loan terms can be in non compliance to maintain current ratio of 3:1, Quick ratio of 2:1 and Return on assets equal to 12%. then bank's right will need to be excercised to liquidate the charged assets to settle outstanding loan.