John Verner is the controller for BioMedic, Inc., a biotechnology company. John is finishing his preparation of the preliminary financial statements for a meeting of the board of directors scheduled for later in the day. At the board’s prior meeting, members discussed the need to report earnings of at least $1.32 per share. It was not mentioned specifically at the meeting, but everyone on the board knows that financial analysts have forecast that BioMedic will report earnings per share (EPS) of $1.32; failure to meet analysts‘ expectations could hurt BioMedic‘s chances of going forward with its planned initial public off ering (IPO) later this year. Unfortunately, the preliminary EPS figure is coming up short. John knows that the board will take a serious look at the estimates and assumptions made in preparing the income statement. In anticipation of the board’s review, John has identified the following two issues:
1. In the past, bad debt expense has been computed using the percentage of sales method.
The percentage used has varied between 3 and 35%. This year, John assumed a rate of
3%. If he were to modify his estimate of bad debt expense to 2.5% of sales, income would increase by $700,000.
2. BioMedic, Inc., offers a warranty on many of the products it sells. Like bad debt expense, warranty expense is computed as a percentage of sales. John is considering modifying his estimate of warranty expense from 1.4% of sales down to 1.1%. This modification would result in a $420,000 increase in net income.
These two changes, considered together, would result in BioMedic being able to report EPS of $1.33 per share, thereby allowing the company to publicly announce that it had exceeded analysts’ expectations. Without these changes, BioMedic will report EPS of $1.21 per share. What issues should John consider before he makes the changes to the income statement? Would John be doing something wrong by making these changes? Would John be breaking the law?