Chapter 5, Problem 5.8APEM

Earnings Management

Ernie Upshaw is the supervising manager of Sleep Tight Bedding. At the end of the year, the company’s accounting manager provides Ernie with the following information, before any adjustment.

Accounts receivable    $500,000

Estimated percent uncollectible    9%

Allowance for uncollectible accounts    $20,000 (debit)

Operating income    $320,000

In the previous year, Sleep Tight Bedding reported operating income (after adjustment) of $275,000. Ernie knows that it’s important to report an upward trend in earnings. This is important not only for Ernie’s compensation and employment, but also for the company’s stock price. If investors see a decline in earnings, the stock price could drop significantly, and Ernie owns a large amount of the company’s stock. This has caused Ernie many sleepless nights.

Required:

  1.    Record the adjustment for uncollectible accounts using the accounting manager’s estimate of 9% of accounts receivable.

  2.    After the adjustment is recorded in Requirement 1, what is the revised amount of operating income? Does operating income increase or decrease compared to the previous year?

  3.    Ernie instructs the accounting manager to record the adjustment for uncollectible accounts using 4% rather than 9% of accounts receivable. After this adjustment, does operating income increase or decrease compared to the previous year?

4.    By how much would total assets and expenses be misstated using the 4% amount?