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Purpose: To analyze the cause and effect of the significant drop of Traditional Industry's (Traditional) 1989 net income, from 1988 record breaking amount number. We have noted the following weaknesses in reporting as the primary cause of Traditional's bankruptcy: Traditional had not properly recorded bad debt expense and account receivable for the year 1988, as such, we will reconstruct the journal entries for bad debt expense and accounts receivable write-offs for 1987, 1988, 1989. If bad debt expense had been properly recorded at 30 % of sales, Traditional will have a net loss of $ 444, 000 in 1988. Management current bad debt expense policy did not appropriately match revenue to expenses incurred, as such, revenue was not properly recognized in accordance to Generally Accepted Account Principle. Traditional's 1987 Annual Report reflected liquidity assertion that was contradictory to the cash flow difficulty shown in the Cash Flow Statement. After analyzing the above weaknesses, we proposed the following recommendation Traditional needs to take a more conservative approach in matching and recognizing revenue and expenses incurred, and practices proper accounting reporting in accordance with the Generally Accepted Accounting Principle, as such 1989 net loss would have been consistent.
Traditional needs to make an effort to minimize the bad debt expense and solve the cash flow problem by selling most of the account receivables without recourse. Reconstruction of journal entries for bad debt expense and accounts receivable write-offs for 1987, 1988, and 1989 along with Traditional 1988 financial statement with doubtful account expense at 30 percent of sale. By using Traditional's Financial Statements, the Allowance for Doubtful Account of the previous years Balance Sheets as the beginning balance, and the Provision for Doubtful Account from the Income Statements as the ending balance, the accounts receivable write-offs for 1987, 1988, and 1989 were $ 5, 101, $ 10, 896, and $ 12, 595 respectively. Thus, the reconstructed journal entries for the write-offs of account receivables are as follows: 1987 1988 1989 Allowance for Doubtful Accounts 5, 101 10, 896 12, 595 Accounts Receivable 5, 101 10, 896 12, 595 The Bad Debt Expense was recorded as stated below: 1987 1988 1989 Bad Debt Expense 10, 843 5, 313 16, 674 Allowance for Doubtful 10, 843 5, 313 16, 674 From these figures we can establish that the estimated Bad Debt Expense in 1988 was greatly underestimated, resulting in the net income for that year to be overestimated.
In 1987 the provision for doubtful accounts exceeded the actual amount of account receivables write-offs with a sizable safety margin. However, in 1988, due to the change in accounting standards regarding revenue recognition, the estimated bad debt expense was decreased dramatically to an insufficient level to cover the account receivable write-offs for that year, which amounted to approximately twice as much as the estimate. But because of the illegitimate decrease in expense, Traditional's Income increased dramatically. However, realizing their mistake a bit too late, in 1989 they went restated their bad debt expense for the year, bringing their income in the red for that year. Net Income for 1988 would have been different if the provision for doubtful accounts expense was calculated as it was in 1987.
Whereas the estimated bad debt expense in 1987 was estimated as 30 percent of sales, in 1988, the percentage was lowered to 11. 3 percent of revenues, due to the new revenue recognition policy that was adopted that year. If Traditional had kept the rate at 30 percent of sales as in 1987, the Income Statement for year 1988 would have looked like this: Selling & Administrative Expense (9, 157) Provision for Doubtful Accounts (14, 286) Earnings before Interest and Taxes 1, 351 Net Loss Per Share (Primary) ($ 0. 136) Net Loss Per Share (Fully Diluted) ($ 0. 109) Thus, instead of reporting earnings of $ 4, 914 for the year Traditional would have recognized a loss of $ 444. Comparison between Generally Accepted Account Principles and current management revenue recognition policy and bad debt expense policy Prior to 1988, Traditional Industries recognized revenue at the time of sale, when the customer signed the contract for the photographic package. However, in 1998, Traditional Industry established the new revenue recognition policy. Under the new policy, the company did not record as sales contracts that had not yet made their first payment, a minor difference in the time of recognition.
Revenues are generally realized when products, merchandise, or other assets are exchanged for cash or claims to cash, when assets received or held are readily convertible into cash or claims to cash. Under that concept of revenue recognition principle, Traditional Industries hold right revenue recognition policy since the contracts, customers signed, would be claims for cash. However, because Traditional Industries allowed customers to make monthly payment for their contracts, they should have followed the Generally Accepted Accounting Principle and use the installment sales methods for revenue recognition rather than at the time of sale prior to 1988. Under the installment sale methods, income recognition is differed until the period of cash collection. Both revenues and costs of sales are recognized in the period of sale but the related gross profit is deferred to those periods in which cash is collected.
Thus, instead of the sale being deferred to the future periods of anticipated collection and then related costs and expense being deferred, only the proportional gross profit is deferred, which is equivalent to deferring both sales and cost of sales. Because the installment sales method emphasizes collection rather than sale, it could provide benefits to Traditional Industries. First, traditional Industries would have reported sales more accurately. Second, Traditional Industries would have measured more accurate and reasonable doubtful receivables rather than estimation of bad expense. Moreover, since there was a high degree of uncertainty about collectibility, Traditional Industries should have deferred revenue recognition until cash was collected. According with Generally Accepted Accounting Principles (GAAP), bad debt expense policies can be determined in three different ways: 1.
Estimated by a percentage of account receivables. 2. By using an aging schedule of account receivables. 3. As a percentage of net credit sales. The managers for Traditional Industries have estimated bad debt expense as a percentage of sales based on the majority of their customers choice to finance their purchases through the company. In 1986 and 1987 Traditional estimated that over 30 % of their sales would be uncollectible. Traditional's managers realized that this percentage was not acceptable and decided to hire more people to handle the collection problem.
In addition, the company introduced a new revenue recognition policy, deferring the point of recognition until the customer made the first payment. While taking a more conservative approach to revenue recognition, Traditional decided to decrease the percentage of sales set aside for bad debt expense to 11. 3 %. This was a serious mistake on Traditional's behalf, as was proved in the end of 1989, when the write-offs of receivables exceeded the provision of doubtful accounts with as much as two times the amount. Traditional handled the situation unethically, manipulating their net income for the year. Traditional's cash flow difficulties In 1987, Traditional cash flow statement indicated a negative cash flow of $ 435, 000 due to high increase in receivables and other current assets. The increased in receivables resulted from the companys policy concerning the customers payments.
Traditional financed the purchases for its customers. The customers repaid their debts to the company using the installment plan, according to which they made monthly payments for a period averaging 30 months. As a result, the company had no cash inflows from sales though the companys sales were high. Negative cash flow indicated that the companys liquidity decreased. The companys current ratio (indicator of the companys liquidity) for 1987: Current ratio = current assets current liabilities = 32018 / 12408 = 2. 66 Traditional's low liquidity can be explained by the time difference between the cash inflows (the customers...
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