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.

(MUST POST FIRST) Initial Post – 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

Scenario :

Beta Computers obtained a large loan from Midland State bank . The covenant of the loan agreement strictly state that if Beta is unable to maintain a Quick ratio, current ratio, and return on assets 12% , the bank has exercise rights to liquidate the companies assets in settlement of loan .

In this scenario, Bank asked for Beta computer Quarterly performance . This will be reviewed by Independent CPA.

Now Companies CEO review Budget number and notice that Sale trend is not in Good shape and it might create problem for Beta in violation of Loan covenant . At present scenario will bring bad fate of 750 employee strength of Beta Company

Current year ( February) Rembrant International planning to acquire “ custom Configured mainframe computers “ . With help of this deal , Beta computer will turnaround and can strengthen revenue and make some money to come out from present problem and also from Bank loan issue

Unfortunately Rembrant having bad credit history and collection of money from Rembrant also distant far

But CEO approved this sale instead of having knowledge that Rembrant having bad credit history , payment challenge as well as high risk

Sale and receivable increase by $ 1.4 Mio

On 31^st March . Edgar Gamma , CPA arrived to do Audit in Beta computer . Gamma immediately recommended to write off $ 1.4 Mio which will be uncollectable.

Gamm told CEO that it is his professional duty to prevent any material misstatement of the company assets

As per IFRS 9under Financial Instrument , new concept in ECL . In any Organization , Auditor has to review debtors ageing report , collection possibility, probability of collection , default risk etc under Expected credit loss methodology . As per ECL method , As per IFRS 9 , credit Impairment model require Impairment allowance for all exposure at the time of disbursement of Loan amount . IFRS 9 definitely bring more judgement on key concept such as whether there has been any significant credit risk increase ,

ECL must be calculated in case of receivable , product mix , loan =EAD*PD*LGD

EAD- Exposure at default , PD = probability of Default LGD = Loss given default LGD mainly represents the share of losses . Actual receivable losses in the event of customer default .

So Gamm need to review all credit loss method and follow IFRS 9 procedure in case of Impairment loss in relates to Loan , Receivable etc . As per above analysis , we noticed that Rembrant credit risj is high and not made payment on time but In case of Beta computer , they have just started working with Rembrant and it will be not good to judge at initial time about complete impairment loss and proposal for write off . Gamm as CPA should observed at least 6 months to 1 year about collection pattern from Rembrant before declare 100% credit impaired and proposal for 100% write off . This is not as per professional guideline .

Third and fourth Quarter budget might be some spike and extra number which might not be able to achieve . At present status, the company is struggling to meet revenue number and there are tremendous shortfall in revenue . So Budget number of sales might not help Gamm