Question

Becky Smith is the manager of a wholesale food company. Her compensation, in part, is incentive-based. In other words, the higher the company income, the higher her incentive compensation. Each year, in an effort to influence her bonus, Becky makes several recommendations, concerning adjusting entries, to the company controller. One of her favorites is to ask the controller to reduce the estimate of doubtful accounts.

1. How does lowering the estimate of doubtful accounts affect the income statement and balance sheet?

2. Is there an ethical consideration in this case? If so, what is it?

3. Should Becky be permitted to weigh in on adjusting entries under these circumstances? Why or why not?

Answer 1

1. The entry for recording reserve for doubtful debts is 'Bad debt expense debited to Reserve for Doubtful debts'. Bad debt expense goes to the income Statement and lowers the income for the year. On the other hand, balance in the Reserve for Doubtful debts go to the balance sheet viz deducted from the outstanding Receivables balance on the asset side. Thus by lowering the proportion of the reserve, it reduces the expense, thus increase the income for the year.

2.Computation of bad debt reserve is compulsory when a person follows accrual basis of accounting. Next, as per the matching concept, all expense relating to the revenue earned needs to be matched against such revenue the year of earning itself. Hence, the bad debts are to be recorded in the year of recognising the revenue. In case the bad debts are recognised in the later periods, it will lead to higher profits in the current period, followed by bringing down the actual profits in the succeeding years. This is wrong.

Finally, financial statements must give true, fair and full disclosure of the company's financial position and performance to its users. Altogether, becky has violated all the above. Hence, her practice is Unethical.

3. There is no point in weighing in to her unscrupulous practise, since it's neither as per the accounting concept, nor as per the accrual system of accounting. Moreover, it is misrepresentation of facts, which is purely unethical and paves a way for making frauds. Hence, Becky has no defense in her favour.