Question) Earnings Management

Case:

I&N Pty Ltd have recently opened a new store in Sydney selling fashionable clothing, competing against retailers including David Jones and Myer. The managing director of I&N Pty Ltd, has invited you to become an investor in the business. You have been provided with the following statement of comprehensive income (all figures in thousands) relating to the first year of operations:

Statement of Comprehensive Income I&N Pty Ltd Year ended May 31, 2014:

Sales revenue 7,490

COGS 1,100

Gross profit 6,390

Operating expenses:

Salaries expense 1,500

Depreciation on equipment expense 100

Rent expense 200

Bad debts expense 15

Other expenses 20

Net profit 4,555

You have done some research on this business and found a number of potential concerns:

To boost sales during the first year of operations, I&N Pty Ltd has extended easy credit to customers. Repayment is not required for 180 days at 0% interest. Many customers during the first 6 months of trading were very dissatisfied with product quality and are non-responsive when sent reminder letters concerning amounts due.

The cost of inventory has increased substantially over the first year of operations as I&N sourced higher quality products. Much of the initial inventory is still in stock as customers choose to purchase the higher quality products now available.

Your inquiries with the financial controller at I&N Pty Ltd indicate the following accounting methods are being used:

First in, first out inventory costing

Direct write off of bad debts

Required:

1. Discuss the appropriateness of the accounting methods used by I&N Pty Ltd with references to guidance provided by Generally Accepted Accounting Principles (GAAP) and accounting standards. (8 marks)

2. To what extent do you think the management of I&N Pty Ltd is attempting to engage in earnings management? Identify and explain any accounting methods you think would provide a more accurate and informative view of this companys financial performance. (6 marks)

3. Justify any additional information that you require to make an informed decision about investment in the business which could include financial and/or management accounting information. (6 marks)