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... used the installment plan) and cash outflows (Traditional compensated suppliers for equipment purchases up-front and paid the commissions to sales representatives at the time of sales). The company had liquidity problems in 1987 despite its optimistic statement in the Annual Reports Financial Review. According to the companys low liquidity we could predict even in 1987 that Traditional would have difficulties in repaying the companys debts later in the future.
And that really happened in 1989 when the company was forced to obtain a loan from three of its directors. The quality of Traditional's earnings. With a high number in account receivables, Traditional needs to recognize their bad debt expense carefully. In 1987, using a more conservative approach, Traditional uses a high percentage of sales in recognizing their bad debt expense estimation. Although their revenue recognition policy does not follow the Generally Accepted Accounting Principle, by recognizing revenue at the time of sale instead of the installment method, management did a good job at matching revenue and expenses. However, in 1988, the company used a new revenue recognition policy where revenue would not be recognized until the customers made the first payment.
In response to the new policy, management reinstated the doubtful account expense to 11. 3 % of revenues, thinking that the new percentage would better match revenue and expenses incurred. As a result of the decrease in bad debt expenses, the earnings for 1988 have been manipulated. The account receivable write-offs almost double the recognized expense, understating the companys expenses, resulting in earnings to be overstated. In 1989, realizing their mistake, the company increased its bad debt expense, from 11. 3 % in the previous year, to 26. 8 % of sale revenues to off set the over flowing account receivables write-offs in the year before. Because of this off set, the 1989 earnings plummet to a huge loss of almost three million dollars. Examination of Traditional's 1987 and 1988 Financial Statements Calculation of the company's financial ratios Company liquidity Current 2. 58 3. 37 Debt management Debt ratio 52 % 64 % Profitability Basic Earning Power 17 % 15 % Looking at the company's financial ratios and how they changed from year 1987 to 1988, we can tell whether the problems of Traditional Industries were predictable.
Current ratio increased from year 1987 to 1988. On the first glance that could mean that the company improved its liquidity. But as we look at asset management ratio Days Sales Outstanding known also as Average Collection Period, we see that it shows a very high number (322 days) in 1987 and increased dramatically by 198, which simply means the company a long time to collect its debt. And the increase in current ratio was due to the increase in account receivables, which according to the company's average collection period were not very liquid. Large numbers represents DSO ratio. That means that it took the company almost a year in 1987 and even more than a year in 1988 to collect cash after the sale was made.
Substantial increase in this number from year 1987 to year 1988 means that it was problematic for the company to collect its debts. Knowing the fact that in 1988 Traditional Industries actually tried some measures in order to fasten its debt collection, we can draw a conclusion that by 1988 the company's problems with debt collection were pretty serious. The debt management ratio shows to what extent a company uses debt financing. The ratio grew 12 % for the period from 1987 to 1988, due to the increase in the companys debts. We also know that the company had negative cash flows both in 1987 and in 1988. Consequently, liquidity of the company's assets was decreasing while its debts were increasing.
Such changes in the company's debt and liquidity meant that the company could start having trouble repaying its own debts. Examining the company's profitability by analyzing the basic earning power ratio, we see that despite the fact that the company's sales grew from 1987 to 1988, its raw earning power decreased by two percent. The company's return on assets also decreased, due to the decrease in company's basic earning power and the increase in debt. However, the company's profit margin (profit per dollar of sale) increased by two percent for the period 1987 - 1988. Speaking about the company's financial statements for 1987 and 1988, we shouldn't forget the fact that the company changed its revenue recognition (and as a result, bad debt recognition) policy in 1988. This way the company could reduce the bad debts on its income statement.
But the real amount of bad debts remained high and was understated on the income statement. As we change the company's income statement by changing its bad debts for 30 % of sales (as they should be estimated), we see the company in a totally different situation. Instead of $ 4, 914, 000 reported in 1988 Income Statement, there would be a $ 444, 000 loss. Therefore, profitability ratios wouldn't be valid. Looking at the company's Income Statement with the bad debts calculated as 30 % of sales, we could see net loss of $ 444, 000 and an increase in bad debts. Such numbers, of course, make the one think that the company is having problems.
And the change in the financial ratios that occurred during the period from 1987 to 1988 (an increase in DSO and debt management ratios) proves that the Traditional Industries' problems were predictable at the end of 1988. Knowing that the bad debt expense account is big during the 1989 years, the best thing to do is shift most of the bad debt expenses to another account by selling most of the account receivables without recourse. By selling most of the account receivables, not only we have minimized expense account, the cash flow problem would also be solved. And for the next accounting period, it is best to constitute new revenue recognition, the install sales method, to better match revenue and expense. When account receivable is sold without recourse, although we receive less profit, we can maintain the bad debt expense to the same number of percentage of sales as the previous year.
When the transaction occurs, we will receive cash, which will solve our cash flow problem and incurred some finance charge expenses, hopefully smaller then the bad debt expense. When Arland Dunn, CEO of Traditional Industries, established the company, there were potential ethical problems. Arland Dunn was involved a similar public company, which declared bankruptcy as a result of liquidity problems and investigations by the Federal Trade Commission, and he didnt change his managerial unethical characteristics after establishing. First, he didnt employ the proper revenue recognition, which misguided investors for Traditional Industries. Traditional Industries exaggerated their income numbers by means of taking the improper revenue recognition policy, which recognized revenue at the time of sales instead of deploying the installment sales method since there was high uncertainty of cash collection. Forbes indicated this problem in terms of publishing a scathing article: Wall Street thrives on numbers.
Too bad the boys and girls dont check them better. Take traditional Industries, which has impressive numbers and a troubled business. Every business entity should disclose accurate and accessible information to the public as well as investors; however, Traditional Industries didnt. Second, Traditional Industries didnt follow a cooling-off period for door-to-door sales law whereby the seller must notify customers that they have the right to cancel the contract within three days. Finally, Traditional Industries characterized its credit plan as open-ended, not close-ended. Under an open-ended credit plan the creditor reasonably contemplates repeated transactions and finance charge are computed from time to time on the outstanding unpaid balance.
However, Traditional Industries did not expect repeated transactions, which should be considered closed-ended credit. Therefore, Traditional Industries didnt provide the information to the buyer regarding finance charge, annual interest rates, payment schedules, total payments, and total sales price. As an auditors point of view, we can easily find the unethical issue of Traditional Industries since their presented financial statement did not provide reasonably adequate information. Bibliography:
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