Ryan Company has as a goal that its earnings per share should increase by at lea
ID: 2459198 • Letter: R
Question
Ryan Company has as a goal that its earnings per share should increase by at least 3% each year; this goal has been attained every year over the past decade. As a result, the market price per share of Ryan's common stock also has increased each year. Last year (2012), Ryan's earnings per share was $3. This year, however, is a different story. Because of decreasing sales, preliminary computations at the end of 2013 show that earnings per share will be only $2.99 per share.
You are the accountant for Ryan. Ryan's controller, Jim Nastic, has come to you with some suggestions. He says, “I've noticed that the decrease in revenues has been primarily related to credit sales. Since we have fewer credit sales, I believe we are justified in reducing our bad debts expense from 4% to 2% of net sales. I also think that because of the decreased sales, we won't use our factory equipment as much, so we can extend its estimated remaining life from 10 to 15 years for computing our straight-line depreciation expense. Based on my calculations, if we make these changes, Ryan's 2013 earnings per share will be $3.06. This will sure make our shareholders happy, not to mention our CEO. You may even get a promotion. What do you think?”
Required:
From financial reporting and ethical perspectives, prepare a response to Jim regarding his suggestions.
Explanation / Answer
From Accounting and Ethical viewpoints, the suggestions of Jim are not acceptable. The calculations for bad debt expense and depreciation need to be based on systematic calculation , not by a thumb rule approach.
The estimate for bad debt is not always related to the credit sales volume alone. The risk rating of the customers involved, the history of payments received from the customer, the current financial condition of the cutomers and the credit rating etc needs to be validated for reaching to a conclusion regarding the estimate for bad debt expense. It does not appear that Jim has that kind of detailed calculation to back up the decison to reduce bad debt expense from 4% to 2%. Therefore reducting the estimated expense without the required reasons will not be correct from accounting point of view and also will not be ethical as the shareholders will be presented with am information which has no basis and the stakeholders will be misguided.
Similarly , depreciation estimate cannot be changed with fluctuation in sales volume. Depreciation is a charge for the cost of the asset. Any reduction in fair value or any obsolescence may lead to revaluation of the assets downwards. But increasing life of asset due to low sales volume is not an acceptable accounting practice and is a manipulation of the accounting data. Depreciation estimate cannot be whimsically changed with fluctuating sales volume, it has to be done as per accounting norms only and with proper justification. Therefore Jim's proposal of increasing asset life is not proper from accounting angle and also not ethical as stakeholders will get misinformation regrading the profitability and EPS of the company.
It is to be remembered that any change in estimate has to be implemented prospectively with clear justification and logic that are accepted from accounting and business point of view. Jim's proposals do not meet those criteria and should not be accepted.
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