Exam 3: Reporting and Analyzing Liabilities,inventory Long-Term Operating Assets, Revenues and Receivables

Correct Answer:

Verified

The main effects of uncollectibles on the financial statements occur as a result of estimation, not the eventual write-off. The amount and timing of the allowances are at the discretion of management. Though a company's auditors must approve the reasonableness of the allowance from uncollectible accounts, they do not possess the inside knowledge of management and are therefore at an information disadvantage in determining the accuracy of allowance estimates. As a result, management can use the estimates to shift income from one year to another. If management underestimates the provision, expense is reduced in the current year, which increases current income. In the future when write-offs do occur which had not been accounted for earlier, the future provision must be increased, thus reducing income in that future period. Hence, income has been shifted from the future into the current period. Companies do this to meet certain current targets which they fear they may fall short of, or to meet current obligations they may be in danger of defaulting on. On the other hand, companies may overestimate the provision for uncollectibles in order to create a cookie jar reserve to use current income to offset tougher times in the future. Companies may opt to take a "big bath" by using an overestimated allowance for uncollected accounts. This reserve can, then, be used to increase future earnings.