Bad Debts Bad Management

Accounting changes and errors

A Bad Error

Background

During management’s 2012 annual review of Bad Inc.’s financial results and application of financial controls, two errors were identified.

Vacation accrual

There was an unintentional mathematical error in computing the vacation accrual for 2011, resulting in a $2.5 million under accrual at Bad Inc.’s 2011 year-end. The calculation of the vacation accrual appears to have been appropriately calculated in 2010.

Bad debt reserve

Management also discovered an error in the computer program used to calculate the bad debt reserve. The computer program uses the aging of each receivable and calculates the necessary bad debt reserve. In late 2012, management determined the program used to calculate the bad debt reserve mistakenly did not consider unapplied cash embedded in the accounts receivable. The cash is applied to the customer account when it is received, but it takes several days to apply this cash to specific outstanding invoices in accounts receivable. Compounding the problem, the accounts receivable aging file is constantly updated and Bad Inc. only has copies of the month-end aging for the last six months. In the first month of 2013, management had the accounts receivable clerk go back and update the aging of all accounts receivable for any unapplied cash on hand at month-end for each of the last six months. The updated aging report was then applied to the bad debt program. The bad debt reserve was overstated by an average of $3.1 million during the six-month period (the highest and lowest of the overstatement were $4.2 million and $1.0 million, respectively). The 2012 year-end bad debt reserve balance was overstated by $3.0 million. In the preliminary closing for 2012, the bad debt reserve was reduced by $3.0 million, to $7.8 million.

Additional financial statement information is provided below (amounts in millions).

Account	As reported 2010	As reported 2011	2012
Bad debt allowance	$ 10.0	$ 11.0	$ 7.8
Accrued vacation liability	$ 7.5	$ 5.7	$ 8.1
Income taxes payable	$ 0.4	$ 0.5	$ 0.4
Bad debt expense	$ 11.2	$ 13.2	$ 10.0
Payroll expense	$120.5	$132.9	$135.0
Pretax income	$ 2.5	$ 1.25	$ 6.0

Other information:

· Bad Inc.’s income tax rate was 20% in 2010 and 2011, but increased to 30% in 2012.

· Before the errors, the company’s net income was $2.0 million in 2010, $1.0 million in 2011 and $4.2 million in 2012.

· Before the errors, the company’s retained earnings totaled a deficit of $900,000 at the beginning of 2010, $1.1 million at the end of 2010, $2.1 million at the end of 2011 and $6.3 million at the end of 2012.

· Bad Inc. borrowed $5.0 million in 2011. Bad Inc. is a private company but has to provide audited comparative financial statements to its lender within 60 days of its year-end. The only two covenants for its loan include a requirement to maintain net income of at least $1.0 million and retained earnings of at least $2.0 million.

· The company is also considering converting from US GAAP to IFRS.

Required

Form a team of three to five members:

· Use ASC 250-10, Accounting Changes and Error Corrections-Overall, and IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, as well as the lecture notes and examples applicable to accounting changes and errors.

· The controller asked you to prepare a draft footnote that provides appropriate disclosure of the two errors under US GAAP and IFRS. The controller told you it is impractical to revise the detailed aging for prior years’ receivables to properly reflect unapplied cash.

· The controller requests that you include a summary of all accounts impacted by these errors. The summary should include columns showing the amount originally reported, the correcting amount and the restated amount for each account impacted by the errors.

A suggested format for each year is as follows (amounts in millions):

Account	As reported 2010	Correction 2010	As restated 2010	As reported 2011	Correction 2011	As restated 2011
Bad debt allowance	$ 10.0			$ 11.00
Accrued vacation	$ 7.5			$ 5.70
Income taxes payable	$ 0.4			$ 0.50
Bad debt expense	$ 11.2			$ 13.20
Payroll expense	$120.5			$132.90
Pretax income	$ 2.5			$ 1.25
Income tax expense	$ 0.5			$ 0.25
Net income	$ 2.0			$ 1.00
Beginning retained earnings	$ (0.9)			$ 1.10
Ending retained earnings	$ 1.1			$ 2.10

· If there are any situations where more information is required to determine the correcting amount, simply insert a question mark.

· The controller asked you to prepare a list of matters he should discuss with the chief financial officer. The company is also considering converting from US GAAP to IFRS. Therefore, consider the implications of this occurring.