Food Processing Company was started one year ago by three managers who had worked in the food processing industry for many years. They had combined their savings plus borrowed extensively from the bank such that the company was able to invest over $10 million to start the business. Their medium-term goal (next four years) is to get the business up and running successfully and then invite others to invest after the fourth year by taking the company public. One of the three managers is now the president, and the other two are vice presidents of production and sales, respectively.
One important issue that the owners are struggling with as they prepare their first audited financial statements is setting policies for estimated bad debt and depreciation expense. Based on their years of experience in the food processing industry they agree that the average bad debts as a percentage of credit sales has been 4%, but has varied from a low of 2.5% to a high of 5.5%. Similarly, for the type of equipment they are using in the manufacturing process, the average useful life has been eight years. Half of the firms in the industry use the double-declining-balance method and the other half use the straight-line method to estimate depreciation expense. The company is using very new technology and methods that give them an initial cost-saving advantage. The equipment makers suggest a 10-year useful life may be reasonable but that the technological competitive advantage may be short lived as other firms adopt this technology.
Bad debt expense and depreciation expense are material and in aggregate will represent upward of 5% (bad debts) and 20% (depreciation) of all expenses for the current year if the most conservative methods of accounting are used. If neutral methods were used the aggregate expense would be 17% versus 12% if these expenses were to be estimated generously or liberally.
Required:
You are the vice president finance and chief financial officer. Write a memo to the executive committee (only the three owners sit on this committee) advising them on your recommendation as to which estimates or methods (neutral, conservative, or liberal) to use to derive bad debt and depreciation expenses.