COMMENT ON THIS POST
Scenario 1: I think Lilyâs board will choose a 4% estimate for bad debt expense. Earnings are high this year, so choosing the higher of the two choices (4% vs. 1%) of bad debt expense wonât be as harmful to earnings, on a percentage basis, versus if earnings had been low. Choosing the 4% will enable Lily Company to âload up the cookie jarâ (as the title of this case suggests) so that if the indicated âunsettled business conditions aheadâ materialize, earnings can be smoothed later since bad debt expense in the âbadâ years can be made lower than it otherwise would have been.
Scenario 2: I think Lilyâs board will choose a 1% estimate for bad debt expense. Since earnings are already quite low, the board will want to show as high a net income as possible, and this can be done, in part, by choosing the lower bad debt expense estimate. Since the board has reason to believe Lily Companyâs operating performance will be better next year, choosing the lower bad debt expense shouldnât adversely affect future yearsâ net income in a material way.
The main risk to Lily Company if the bad debt estimate is chosen using only the type of information given here is that financial statements may not accurately represent the companyâs financials since cookie jar reserves are being used to smooth earnings over time. This can result in worse opinions of the company by potential investors as well as regulators
COMMENT ON THIS POST
Scenario 1: I think Lilyâs board will choose a 4% estimate for bad debt expense. Earnings are high this year, so choosing the higher of the two choices (4% vs. 1%) of bad debt expense wonât be as harmful to earnings, on a percentage basis, versus if earnings had been low. Choosing the 4% will enable Lily Company to âload up the cookie jarâ (as the title of this case suggests) so that if the indicated âunsettled business conditions aheadâ materialize, earnings can be smoothed later since bad debt expense in the âbadâ years can be made lower than it otherwise would have been.
Scenario 2: I think Lilyâs board will choose a 1% estimate for bad debt expense. Since earnings are already quite low, the board will want to show as high a net income as possible, and this can be done, in part, by choosing the lower bad debt expense estimate. Since the board has reason to believe Lily Companyâs operating performance will be better next year, choosing the lower bad debt expense shouldnât adversely affect future yearsâ net income in a material way.
The main risk to Lily Company if the bad debt estimate is chosen using only the type of information given here is that financial statements may not accurately represent the companyâs financials since cookie jar reserves are being used to smooth earnings over time. This can result in worse opinions of the company by potential investors as well as regulators
