You have been recently hired as an assistant controller for XYZ Industries, a large, publically held manufacturing company. Your immediate supervisor is the controller who also reports directly to the VP of Finance. The controller has assigned you the task of preparing the year-end adjusting entries. In the receivables area, you have prepared an aging accounts receivable and have applied historical percentages to the balances of each of the age categories. The analysis indicates that an appropriate estimated balance for the allowance for uncollectible accounts is $180,000. The existing balance in the allowance account prior to any adjusting entry is a $20,000 credit balance.

After showing your analysis to the controller, he tells you to change the aging category of a large account from over 120 days to current status and to prepare a new invoice to the customer with a revised date that agrees with the new aging category. This will change the required allowance for uncollectible accounts from $180,000 to $135,000. Tactfully, you ask the controller for an explanation for the change, and he tells you, We need the extra income; the bottom line is too low.

Required:
a. What is the effect on income before taxes of the change requested by the controller? Consider your options and responsibilities along with the possible consequences of any action you might take.
b. Discuss the ethical dilemma you face and what you would do. Do you agree with your classmates' intended actions?

The Income before Taxes would be $45,000 ($180,000 - $20,000) - ($135,000 - 20,000) more than the income that should have been reported. Assuming the Income Taxes were to be based on the increased income figure, XYZ would have an increased tax liability by say $18,000 (45,000 x 40%). This reduces the Retained Earnings (or Stockholders Equity) by $18,000. The company would in actual fact, be reporting a net income of $27,000 more than it should have reported. This is very deceptive for all those who would be using the reported financial statement in making their decisions. Unfortunately, we would have showed the affected customer that we are dubious in our business practise, further jeopardizing the chance of full recovery of the debt. This is apart from taking into consideration the type of customer that would be ready to accept a revised invoice that was formerly past due.

b. The ethical dilemma is doing the right thing according to Rights Theory. We cannot say we have adhered to a set of rules (the U.S GAAP or the IFRS) when in fact we are violating an important rule of fair presentation of the elements of the financial statement.

I would try to convince the controller to rescind his suggestion and follow the rules. We understand that making allowance for uncollectibles is an estimate based on judgement. However, since we have established the basis and even stated it in the notes to the financial statements, I think that we should follow through.

Explanation:

The year's Uncollectible Expense should be $160,000 ($180,000 - $20,000). If the allowance for the year were to be adjusted from $180,000 to $135,000, it means that the Uncollectible Expense would then be $115,000 ($135,000 - $20,000). We will be under-reporting the Uncollectible Expense by a difference of $45,000 ($160,000 - $115,000), thereby boosting the net income before tax by $45,000.