The CM 2 management team is discussing how it can “put its best foot forward” in
ID: 2777235 • Letter: T
Question
The CM2 management team is discussing how it can “put its best foot forward” in regards to the anticipated stock offering at the end of 2013. They recognize that the financial statements will be extremely important in determining the success or failure of this stock offering. They also recognize that the higher CM2’s reported net income and the stronger its balance sheet, the more likely that CM2 will achieve a higher stock price in this initial offering
Part I
One accounting issue the management team is discussing relates to the accounting for bad debt expense. CM2 currently charges bad debt expense based on a percentage of receivables. The rate used is 13% of ending accounts receivable. Two of the management team want to forget about bad debt expense altogether. They argue that there is no cash flow effect related to this expense. Therefore, they ask, why increase expenses and reduce net income? The other two members of the management team take a different position. They believe bad debt expense has to be recorded but believe it should be recorded only when the receivable is declared to be uncollectible. Using this direct write-off approach will lead to less bad debt expense in the current year and therefore higher net income.
You are surprised by this entire discussion. You thought everyone understood the accrual system of accounting. You jump into the discussion to explain the proper accounting for bad debts. The management team is skeptical and asks you to explain in writing why bad debt expense should continue to be reported on an accrual basis.
Instructions
Write a memo to the management team explaining why the approaches they suggest are not in conformance with generally accepted accounting principles. Be sure to explain why the present accounting is correct.
Part II
Another approach to increase net income is also being considered. Some members of the CM2 management team believe that the company might provide incentives to present and potential customers to purchase its products. Presently only a few select customers receive a small sales discount if they pay promptly. CM2 is considering offering this sales incentive to all its customers and changing the present terms from 1/10, n/ 20 either to 2/10, n/30 or to 4/15, n/45. In addition the CM2 managers wonder whether the use of trade discounts might increase sales significantly.
Instructions
Write a memorandum to management, explaining what the terms 2/10, n/30 and 4/15, n/45 mean. What will be the likely effect on the balance sheet if one or the other of these discount terms is used? What does the term “trade discount” mean? What might be the advantage of using trade discounts rather than sales discounts to enhance sales revenue?
Explanation / Answer
Part I:
The current method of calculating bad debt expenses which is 13% of Accounts Receivables is correct. No need of any alterations.
Counter party risk is always involved when sales are made on credit. A company cannot recover its entire A/R on the balance sheet. So instead of taking the hit directly on the financial health of the company, it is a best practice to have accrual basis for bad debt expenses in order to save the financial performance of a company in a particular year when a counter party has defaulted on the credit they owe to the company. If you feel like increasing the net income, maximum we can do is reduce the percentage of this expense, lets say to 10% of accounts receivables instead of 13%.
If this expense is completely removed from our statements, the company's financial statements takes a bigger hit when a default will happen.
Part II:
2/10, n/30 means 2% discount if paid the cash in 10 days, or else pay the full amount in 30 days
4/15, n/45 means 4% discount if paid the cash in 15 days, or else pay the full amount in 45 days
Both these methods will increase the discounts on the cash payments in advance but increase the credit period from 20 days to either 30 days or 45 days. If these methods are adopted, our customers will pay the amounts they owe us a little sooner to earn discounts on their payments. So Accounts receivables will be decreased and cash in hand will increase by the same amount making no change to the current assets.
Trade discount is giving discount on the selling price. It is different from cash discounts, which is more specific to the payments made rather than the number of goods sold. By giving trade discounts, the company may increase its overall sales, and also net income. This would be a better strategy to increase net income by carefully promoting products, with higher margins at lower prices than the current market prices.