Assume that you are conducting the audit of College Ware, a manufacturer and distributor of printed, embroidered, and embossed specialty clothing and gift items marketed to college students with school-specific logos. The company pays licensing fees and manufactures products in advance of the fall and winter peak sales periods. The stores that sell the company's products have a contractual agreement that they may return a percentage of unsold merchandise. During August 2006, many stores in the University of Wisconsin and University of Illinois markets canceled orders just before the start of the school year because of changes in school logos. In addition, the percentage of unsold merchandise, and associated returns, was higher than normal for these stores. As a result, College Ware has made an adjusting entry to record a loss due to market decline of inventory (Dr. Loss Due to Market Decline of Inventory, and Cr. Allowance to Reduce Inventory to Market Value for $40,000).You as the auditor have conducted a physical inventory of the products and, based upon sales data collected from College Ware’s competitors, you are convinced that the write-down should be for $90,000 (a materially higher amount).
Another issue in the College Ware audit is that the company has started implementing plans to change their marketing strategy to include more sales of general purpose clothes and gift items to mass merchandising retailers. These retailers are larger, and the initial receivables payments indicate that they present a more reliable pattern of payments, with fewer uncollectible amounts. As such, management has argued that the allowance for doubtful accounts should be reduced and has made the associated adjusting entry (Dr. Allowance for Doubtful Accounts, Cr. Other Revenue for $40,000). In the past, you had questioned College Ware management about their steady increase in the Allowance for Doubtful Accounts, which had risen by about 3% per year for each of the past five years even though the rate of customer default on their receivables had remained steady over that time. However, you had never insisted that management revise their allowance downward since you considered management's estimates to be conservative (i.e., they reduced income rather than increased income). In your opinion, the allowance for doubtful accounts probably should be reduced, although it is hard to judge exactly the amount by which the reduction should be recorded because of the relatively recent change in the marketing strategy. In other words, it is difficult for you to dispute whether management's current adjusting entry is recorded at the correct amount.

Required
a. Comment on why management of College Ware may have an incentive to reduce the allowance for doubtful accounts this year.
b. The overly conservative accounting estimates used by management in their valuation of accounts receivable represent what is commonly referred to as "cookie jar reserves." Using this financial reporting strategy, management sets aside money in allowance accounts that they plan to remove later to cover future losses. In doing so, management allows itself discretion to report income at smoother levels than would otherwise be achieved had the cookie jar reserves not been put in place. Comment on the ethical implications of management's financial reporting strategy.
c. Comment on the auditor's ethical difficulty in this type of scenario. Specifically, why might auditors find it difficult to urge companies not to set up cookie jar reserves?
d. Develop a list of options for how the auditor might resolve the issues raised in this case, and specifically describe additional audit evidence that the auditor would need to collect regarding the various options.