Introduction
The management of cash and accounts including the notes receivable is vital to maintaining sufficient liquidity. These assets can also include accounts payable and inventories. Thus in business, players must address five key issues when dealing with cash and receivables. These issues include; setting credit policies, managing cash needs, evaluating the values of accounts receivable, financing accounts receivable, and finally making ethical estimates of credit losses (Needles, Powers, and Crosson, 2006, p.370).
Accounts receivable and cash are part of the short-time financial assets. However, accounts receivable arise from extending credit to individual customers or other companies. This type of credit is often known as trade credit and its terms of trade usually range from 5 to 60 days depending on the business practices in place (Needles et al., 2006, p. 372). Most companies extend credits in the hope of increasing their sales and earnings. However, some customers may take longer to pay for the goods or services rendered. These types of customer accounts are referred to as uncollectible accounts or bad debts. These accounts should be included in the balance sheets as expenses arising from selling on credit.
Some companies cater for this loss upon determining that an account cannot be collected by reducing the accounts receivable and increasing the uncollectible account’s value to the value of the uncollectible account. This is in line with the federal regulations that require most companies to use this method of identifying losses also known as the direct charge-off method used for computing taxable income (West, 2008, p.394). However, most companies that follow GAAP prefer using the allowance method.
The allowance method allows the analyst to match the expenses from uncollectible accounts against the revenues generated by these accounts. This is done at the time the sales are made and since it is not possible to determine which accounts will not be paid, the management must make estimates of the losses that arise when observing the matching rule. The estimates are then treated as expenses when recording the sales done. When recording the allowance for uncollectible accounts, the bad debts must appear in the Debit column. Meanwhile, the accounts that have been collected are recorded in the Credit column so as to balance off with the bad debts as shown below:
Meanwhile, when the bad debts take a long period of time to be collected, there is a need to remove them periodically. These accounts should be removed from both the accounts receivable balance and also from the uncollectible accounts allowance column (Nelson, 2010, p.49). As indicated in the table below:
Although reducing the allowance for uncollectible accounts can aid in increasing the overall net sales percentage, it can also show varied effects on most other sections of the business. The sections and parties that can be affected by this move include company management, shareholders, and even the individual debtors or companies. It may also have effects on the total earnings reflected on the balance sheet and income statements.
Reduction of allowances for Uncollectible accounts
What are the effects of the move on the parties involved in the business?
This move can affect the parties involved either positively or negatively. The major players in business include; the management, the stockholders, the customers or clientele, and the tax regulatory authorities. Since this move seeks to manipulate the estimates required in the projection of future losses, it can affect the reported earnings in several ways. This move will allow the management to report improved earnings which in turn will enhance the company’s stock price and thus increase the EPS and the dividends to each stockholder (West, 2008, p.380). It also increases the bonuses of the company’s executives while allowing debtors more time to pay and giving the management the opportunity to make the necessary corrections. However, the move will also increase the total taxable income to the disadvantage of the company while giving the shareholders a false picture of the company’s financial status.
What are the effects of the move on the income statement and balance sheets?
Estimates arising from bad debts are referred to as doubtful accounts which are accounts that reduce the amount of the accounts receivable. Therefore, any change to these accounts in the balance can also affect the uncollectible accounts expenses reflected in the income statements. By reducing the allowance for the doubtful accounts, the management will be in a position of presenting a large value for accounts receivable that will be turning to cash. Since the uncollectible accounts are only estimated and not stated exactly, a company’s earnings can be overstated in the income statement by reducing the allowance for uncollectible accounts (West, 2008, p.377).
What are the effects of the move on income statements and balance sheets in the future period?
The estimates from uncollectible accounts are useful during financial reporting and not for reporting income taxes. Therefore, the company management prefers to deduct these expenses later in time when it is certain that the account in question cannot be collected. Since the move overstates the earnings for the current period by underestimating the number of losses, future earnings will be reduced greatly and fail to meet the benchmarks for bonuses (West, 2008, p.377).
How can the chief financial officer justify this move?
The CFO may justify this move by showing that the underestimated uncollectible accounts are assets that the company owns only that they are tied up in accounts receivable in the future. In the future, the company can raise funds by selling or transferring the accounts receivable to another entity also known as a factor. Factoring the accounts receivable can be done with or without recourse (West, 2008, p.387). Factoring with recourse implies that the company will be held responsible for accounts that cannot be collected while factoring without recourse means that the company is no longer responsible for the accounts receivable that cannot be collected. Additionally, the generally accepted accounting principles (GAAP), allow the management to be flexible in choosing the accounting method in estimating. This also gives the management a judicious option of choosing the method for financial reporting in such a way that the results are presented in the best interest of the company or management (Peterson and Fabozzi, 1999, p.51).
How can the internal auditor detect this earnings management activity?
Since accruals arising from sales on credit are part of the business, as the sales increases, the value of accounts receivable increases equally. Estimates from bad debts also known as doubtful accounts are deducted from accounts receivable. Therefore, it is easy to detect changes in these accounts since, for most companies, the allowance for doubtful accounts divided by the gross accounts receivable is always relatively constant (Peterson and Fabozzi, 1999, p.53).
What are the effects of this move on the moral compass of the company? What are the repercussions of this action?
Since this move is aimed at manipulating the financial statement of the company by the management in its favor, it can be treated as a GAAP violation. This also implies that the management can no longer be trusted since this move is taken with the assumption that outsiders cannot easily detect the alteration. This can also be treated as a form of corruption on the part of the company accountant.
The repercussions of this action can involve facing lawsuits filed by the shareholders of the company against the management and can thus result in a restatement of the reported financial statements (Peterson and Fabozzi, 1999, p.54).
Conclusion
It is worth noting that the quality of the financial statement matters a lot to the shareholders and creditors of a company. Therefore, it is the responsibility of the management to ensure that these statements are presented in the format that reflects the standards and guidelines raid down in the GAAP. This is mainly because, these statements have important financial consequences including determining the value of the company, evaluating the credit quality of the company’s debt obligations among others.
Additionally, financial statements prepared without taking the GAAP guidelines into consideration can lead to various financial problems as discussed above. Therefore the importance of following these guidelines cannot be overemphasized, they are necessary whichever the case.
Reference List
Nelson, S.L. (2010). QuickBooks 2010: all-in-one for dummies. Wiley Publishing, Inc.: Hoboken. Web.
Peterson, P.P., and Fabozzi, J. F. (1999). Analysis of financial statements. Frank J. Fabozzi Associates: New Hope, Pennsylvania. Web.
West, A. (2008). Financial and managerial: accounting, 8th edn. Houghton Mifflin Company: USA. Web.