Traditional Industries Case studies
Purpose: To analyze the cause and effect of the significant drop of Traditional Industry¡¯s (¡°Traditional¡±) 1989 net income, from 1988 record breaking amount number.
We have noted the following weaknesses in reporting as the primary cause of Traditional¡¯s bankruptcy:
¡× Traditional had not properly recorded bad debt expense and account receivable for the year 1988, as such, we will reconstruct the journal entries for bad debt expense and accounts receivable write-offs for 1987,1988, 1989. If bad debt expense had been properly recorded at 30% of sales, Traditional will have a net loss of $444,000 in 1988.
¡× Management current bad debt expense policy did not appropriately match revenue to expenses incurred, as such, revenue was not properly recognized in accordance to Generally Accepted Account Principle.
¡× Traditional¡¯s 1987 Annual Report reflected liquidity assertion that was contradictory to the cash flow difficulty shown in the Cash Flow Statement.
After analyzing the above weaknesses, we proposed the following recommendation
¡× Traditional needs to take a more conservative approach in matching and recognizing revenue and expenses incurred, and practices proper accounting reporting in accordance with the Generally Accepted Accounting Principle, as such 1989 net loss would have been consistent.
¡× Traditional needs to make an effort to minimize the bad debt expense and solve the cash flow problem by selling most of the account receivables without recourse.
Discussion and Analysis:
¡× Reconstruction of journal entries for bad debt expense and accounts receivable write-offs for 1987, 1988, and 1989 along with Traditional 1988 financial statement with doubtful account expense at 30 percent of sale.
By using Traditional¡¯s Financial Statements, the Allowance for Doubtful Account of the previous year¡¯s Balance Sheets as the beginning balance, and the Provision for Doubtful Account from the Income Statements as the ending balance, the accounts receivable write-offs for 1987, 1988, and 1989 were $5,101, $10,896, and $12,595 respectively. Thus, the reconstructed journal entries for the write-offs of account receivables are as follows:
1987 1988 1989
Allowance for Doubtful Accounts 5,101 10,896 12,595
Accounts Receivable 5,101 10,896 12,595
The Bad Debt Expense was recorded as stated below:
1987 1988 1989
Bad Debt Expense 10,843 5,313 16,674
Allowance for Doubtful 10,843 5,313 16,674
From these figures we can establish that the estimated Bad Debt Expense in 1988 was greatly underestimated, resulting in the net income for that year to be overestimated. In 1987 the provision for doubtful accounts exceeded the actual amount of account receivables write-offs with a sizable safety margin. However, in 1988, due to the change in accounting standards regarding revenue recognition, the estimated bad debt expense was decreased dramatically to an insufficient level to cover the account receivable write-offs for that year, which amounted to approximately twice as much as the estimate. But because of the illegitimate decrease in expense, Traditional¡¯s Income increased dramatically. However, realizing their mistake a bit too late, in 1989 they went restated their bad debt expense for the year, bringing their income in the red for that year.
Net Income for 1988 would have been different if the provision for doubtful accounts expense was calculated as it was in 1987. Whereas the estimated bad debt expense in 1987 was estimated as 30 percent of sales, in 1988, the percentage was lowered to 11.3 percent of revenues, due to the new revenue recognition policy that was adopted that year. If Traditional had kept the rate at 30 percent of sales as in 1987, the Income Statement for year 1988 would have looked like this:
Income Statement 1988 (in $000)
Other Revenues & Gains 6,090
Total Sales 47,621
Cost of Goods Sold (22,827)
Selling & Administrative Expense (9,157)
Provision for Doubtful Accounts (14,286)
Earnings before Interest and Taxes 1,351
Interest Expense (2,023)
Income Tax Expense* 228
Net Loss (444)
Net Loss Per Share (Primary) ($0.136)
Net Loss Per Share (Fully Diluted) ($0.109)
*Statutory tax rate was 34% in 1988
Thus, instead of reporting earnings of $4,914 for the year Traditional would have recognized a loss of $444.
¡× Comparison between Generally Accepted Account Principles and current management revenue recognition policy and bad debt expense policy
Prior to 1988, Traditional Industries recognized revenue at the time of sale, when the customer signed the contract for the photographic package. However, in 1998, Traditional Industry established the new revenue recognition policy. Under the new policy, the company did not record as sales contracts that had not yet made their first payment, a minor difference in the time of recognition. Revenues are generally realized when products, merchandise, or other assets are exchanged for cash or claims to cash, when assets received or held are readily convertible into cash or claims to cash. Under that concept of revenue recognition principle, Traditional Industries hold right revenue recognition policy since the contracts, customers signed, would be claims for cash. However, because Traditional Industries allowed customers to make monthly payment for their contracts, they should have followed the Generally Accepted Accounting Principle and use the installment sales methods for revenue recognition rather than at the time of sale prior to1988.
Under the installment sale methods, income recognition is differed until the period of cash collection. Both revenues and costs of sales are recognized in the period of sale but the related gross profit is deferred to those periods in which cash is collected. Thus, instead of the sale being deferred to the future periods of anticipated collection and then related costs and expense being deferred, only the proportional gross profit is deferred, which is equivalent to deferring both sales and cost of sales.
Because the installment sales method emphasizes collection rather than sale, it could provide benefits to Traditional Industries. First, traditional Industries would have reported sales more accurately. Second, Traditional Industries would have measured more accurate and reasonable doubtful receivables rather than estimation of bad expense. Moreover, since there was a high degree of uncertainty about collectibility, Traditional Industries should have deferred revenue recognition until cash was collected.
According with Generally Accepted Accounting Principles (GAAP), bad debt expense policies can be determined in three different ways:
1. Estimated by a percentage of account receivables.
2. By using an aging schedule of account receivables.
3. As a percentage of net credit sales.
The managers for Traditional Industries have estimated bad debt expense as a percentage of sales based on the majority of their customers¡¯ choice to finance their purchases through the company. In 1986 and 1987 Traditional estimated that over 30% of their sales would be uncollectible. Traditional¡¯s managers realized that this percentage was not acceptable and decided to hire more people to handle the collection problem. In addition, the company introduced a new revenue recognition policy, deferring the point of recognition until the customer made the first payment. While taking a more conservative approach to revenue recognition, Traditional decided to decrease the percentage of sales set aside for bad debt expense to 11.3%. This was a serious mistake on Traditional¡¯s behalf, as was proved in the end of 1989, when the write-offs of receivables exceeded the provision of doubtful accounts with as much as two times the amount. Traditional handled the situation unethically, manipulating their net income for the year.
¡× Traditional¡¯s cash flow difficulties
In 1987, Traditional cash flow statement indicated a negative cash flow of $435,000 due to high increase in receivables and other current assets. The increased in receivables resulted from the company¡¯s policy concerning the customers¡¯ payments. Traditional financed the purchases for its customers. The customers repaid their debts to the company using the installment plan, according to which they made monthly payments for a period averaging 30 months. As a result, the company had no cash inflows from sales though the company¡¯s sales were high.
Negative cash flow indicated that the company¡¯s liquidity decreased. The company¡¯s current ratio (indicator of the company¡¯s liquidity) for 1987:
Current ratio = current assets \ current liabilities = 32018/12408 = 2.66
Traditional¡¯s low liquidity can be explained by the time difference between the cash inflows (the customers used the installment plan) and cash outflows (Traditional compensated suppliers for equipment purchases up-front and paid the commissions to sales representatives at the time of sales).
The company had liquidity problems in 1987 despite its optimistic statement in the Annual Report¡¯s ¡°Financial Review.¡± According to the company¡¯s low liquidity we could predict even in 1987 that Traditional would have difficulties in repaying the company¡¯s debts later in the future. And that really happened in 1989 when the company was forced to obtain a loan from three of its directors.
¡× The quality of Traditional¡¯s earnings.
With a high number in account receivables, Traditional needs to recognize their bad debt expense carefully. In 1987, using a more conservative approach, Traditional uses a high percentage of sales in recognizing their bad debt expense estimation. Although their revenue recognition policy does not follow the Generally Accepted Accounting Principle, by recognizing revenue at the time of sale instead of the installment method, management did a good job at matching revenue and expenses.
However, in 1988, the company used a new revenue recognition policy where revenue would not be recognized until the customers made the first payment. In response to the new policy, management reinstated the doubtful account expense to 11.3% of revenues, thinking that the new percentage would better match revenue and expenses incurred. As a result of the decrease in bad debt expenses, the earnings for 1988 have been manipulated. The account receivable write-offs almost double the recognized expense, understating the company¡¯s expenses, resulting in earnings to be overstated.
In 1989, realizing their mistake, the company increased its bad debt expense, from 11.3% in the previous year, to 26.8% of sale revenues to off set the over flowing account receivables write-offs in the year before. Because of this off set, the 1989 earnings plummet to a huge loss of almost three million dollars.
¡× Examination of Traditional¡¯s 1987 and 1988 Financial Statements
Calculation of the company's financial ratios
Ratio name 1987 1988
Company liquidity Current 2.58 3.37
Asset management DSO 322 429
Debt management Debt ratio 52% 64%
Profitability Basic Earning Power 17% 15%
ROA 8% 7%
Profit margin 10% 12%
Looking at the company's financial ratios and how they changed from year 1987 to 1988, we can tell whether the problems of Traditional Industries were predictable.
Current ratio increased from year 1987 to 1988. On the first glance that could mean that the company improved its liquidity. But as we look at asset management ratio Days Sales Outstanding known also as Average Collection Period, we see that it shows a very high number (322 days) in 1987 and increased dramatically by 198, which simply means the company a long time to collect its debt. And the increase in current ratio was due to the increase in account receivables, which according to the company's average collection period were not very liquid.
Large numbers represents DSO ratio. That means that it took the company almost a year in 1987 and even more than a year in 1988 to collect cash after the sale was made. Substantial increase in this number from year 1987 to year 1988 means that it was problematic for the company to collect its debts. Knowing the fact that in 1988 Traditional Industries actually tried some measures in order to fasten its debt collection, we can draw a conclusion that by 1988 the company's problems with debt collection were pretty serious.
The debt management ratio shows to what extent a company uses debt financing. The ratio grew 12% for the period from 1987 to 1988, due to the increase in the company¡¯s debts. We also know that the company had negative cash flows both in1987 and in 1988. Consequently, liquidity of the company's assets was decreasing while its debts were increasing. Such changes in the company's debt and liquidity meant that the company could start having trouble repaying its own debts.
Examining the company's profitability by analyzing the basic earning power ratio, we see that despite the fact that the company's sales grew from 1987 to 1988, its raw earning power decreased by two percent. The company's return on assets also decreased, due to the decrease in company's basic earning power and the increase in debt. However, the company's profit margin (profit per dollar of sale) increased by two percent for the period 1987-1988.
Speaking about the company's financial statements for 1987 and 1988, we shouldn't forget the fact that the company changed its revenue recognition (and as a result, bad debt recognition) policy in 1988. This way the company could reduce the bad debts on its income statement. But the real amount of bad debts remained high and was understated on the income statement. As we change the company's income statement by changing its bad debts for 30% of sales (as they should be estimated), we see the company in a totally different situation. Instead of $4,914,000 reported in 1988 Income Statement, there would be a $444,000 loss. Therefore, profitability ratios wouldn't be valid. Looking at the company's Income Statement with the bad debts calculated as 30% of sales, we could see net loss of $444,000 and an increase in bad debts. Such numbers, of course, make the one think that the company is having problems. And the change in the financial ratios that occurred during the period from 1987 to 1988 (an increase in DSO and debt management ratios) proves that the Traditional Industries' problems were predictable at the end of 1988.
Knowing that the bad debt expense account is big during the 1989 years, the best thing to do is shift most of the bad debt expenses to another account by selling most of the account receivables without recourse. By selling most of the account receivables, not only we have minimized expense account, the cash flow problem would also be solved. And for the next accounting period, it is best to constitute new revenue recognition, the install sales method, to better match revenue and expense.
When account receivable is sold without recourse, although we receive less profit, we can maintain the bad debt expense to the same number of percentage of sales as the previous year. When the transaction occurs, we will receive cash, which will solve our cash flow problem and incurred some finance charge expenses, hopefully smaller then the bad debt expense.
When Arland Dunn, CEO of Traditional Industries, established the company, there were potential ethnical problems. Arland Dunn was involved a similar public company, which declared bankruptcy as a result of liquidity problems and investigations by the Federal Trade Commission, and he didn¡¯t change his managerial unethical characteristics after establishing. First, he didn¡¯t employ the proper revenue recognition, which misguided investors for Traditional Industries. Traditional Industries exaggerated their income numbers by means of taking the improper revenue recognition policy, which recognized revenue at the time of sales instead of deploying the installment sales method since there was high uncertainty of cash collection. Forbes indicated this problem in terms of publishing a scathing article:
¡°Wall Street thrives on numbers. Too bad the boys and girls don¡¯t check them better.
Take traditional Industries, which has impressive numbers and a troubled business.¡±
Every business entity should disclose accurate and accessible information to the public as well as investors; however, Traditional Industries didn¡¯t. Second, Traditional Industries didn¡¯t follow a cooling-off period for door-to-door sales law whereby the seller must notify customers that they have the right to cancel the contract within three days. Finally, Traditional Industries characterized its credit plan as open-ended, not close-ended. Under an open-ended credit plan the creditor reasonably contemplates repeated transactions and finance charge are computed from time to time on the outstanding unpaid balance. However, Traditional Industries did not expect repeated transactions, which should be considered closed-ended credit. Therefore, Traditional Industries didn¡¯t provide the information to the buyer regarding finance charge, annual interest rates, payment schedules, total payments, and total sales price. As an auditor¡¯s point of view, we can easily find the unethical issue of Traditional Industries since their presented financial statement did not provide reasonably adequate information.
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