Question

Why do companies find it convenient to alter allowance for bad debts to manage earnings?

GAAP prescribes a range of allowances for bad debts for each industry and management can choose any number within that range.

Bad debt allowance is an estimate and can be justified based on management's discretion or opinion under GAAP.

It is one of the options that offers the greatest benefit to a company.

The Sarbanes-Oxley Act has closed off all other loopholes used to manage earnings.

Answer 1

option (a) This statement is incorrect. GAAP does not prescribes any range. It only provides methodology known as expected credit losses which is again based upon management estimates.

option (b) This statement is correct. Estimate of bad debt requires management's judgement and opinion. It is management who can decide whether any receivable is realizable or not.

option (c) This statement is also incorrect. It does not provide any benefit to the company. It is an expense for the companies.

option (d) No Sarbanes Oxley only authorizes the approval process of estimation of bad debt. If the management wants to manipulate they can easily do it.

On the basis of analysis, we can conclude that option (b) is the correct answer.