Assume that you are conducting the audit of CollegeWare, a publicly held 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 the current audit year, 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, CollegeWare has made an adjusting entry to record a loss caused by market decline of inventory (Dr. loss because of marketdecline of inventory, 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 CollegeWare's competitors, you are convinced that the write-down should be for $90,000 (a materially higher amount).
Another issue in the CollegeWare audit is that the company has started implementing plans to change its 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 CollegeWare management about its 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 receivables had remained steady over that time. However, you had never insisted that management revise its allowance downward because 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 CollegeWare may have an incentive to reduce the allowance for doubtful accounts this year.
b. The overly conservative accounting estimates used by management in its 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 it plans 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 implications of management's financial reporting strategy.
c. Use the ethical framework introduced in Chapter 3 to address the dilemmas faced by the auditor regarding what the auditor should require the client to do regarding the client's inventory and accounts receivable balances. Recall that the steps in the framework are as follows:
● Identify the ethical issue(s).
● Determine who are the affected parties and identify their rights.
● Determine the most important rights.
● Develop alternative courses of action.
● Determine the likely consequences of each proposed course of action.
● Assess the possible consequences, including an estimation of the greatest good for the greatest number.
● Decide on the appropriate course of action.