You are the chief accountant for ZM Corp., which is located in Illinois. In Nove

Question

You are the chief accountant for ZM Corp., which is located in Illinois. In November 2017, that state had the second highest unemployment rate in the Midwest: 4.9% (down from 6.1% in January 2015).1 For the past few years, you have noticed that the company’s bad debt rate has been about 7% of year-end accounts receivable. That rate of bad debts has severely affected the company’s profitability…especially since management has steadily been lowering the standards for granting credit to customers.

Your salary structure (as well as that of other corporate managers) allows for a bonus when net income is equal to or greater than a specific percentage of net sales. Unfortunately, that profit metric has not been reached in four years. However, the CEO and CFO (who is retiring after the first quarter of 2018) realized that a change in the bad debts percentage would allow them and you to obtain bonuses in 2017. If bad debts were computed at 2% of year-end A/R rather than 7%, everyone would receive a reasonable (but not extreme) bonus for 2017. The CEO justifies the use of that rate by concluding that, since unemployment in Illinois has been decreasing over the past few years, so will bad debts.

Would making such a change in the bad debts estimate violate any basic accounting concepts? Explain your yes or no answer.

Explanation / Answer

Yes, making such a change in the bad debts will definately voilate the prudence concept of accounting.

Under the prudence concept, it is required to not over estimate the amount of revenue, assets or profits and to not underestimate the amount of expenses, liabilities or losses.

By changing the bad debts rate from 7% to 2%, the company will under estimate its expenses and over estimate its profits, thus violating the prudence concept.

The CEO justification of decrease in unemployment rate is not correct as the bad debts is increasing due to the management being lowering its standards for granting credit to customers. Management should work on its credit policies and it will reduce the bad debts rate.

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