Shilstone Supply, Inc. manufactures a variety of pumps and valves that are distributed through several thousand plumbing supply houses, as well as 100 manufacturer's representatives. Due to lessthan favorable business conditions in the industry over the last several years, Shilstone's cash flow position has deteriorated. Over the past four years, the company's Accounts Receivable balance grew from 5 to 9% of assets, and its current ratio declined from 2.8 to 2.0. Over the same period, bad debts grew from 1.5 to 3% of sales. Debt covenants with Shilstone's bank require that the current ratio be above 2.1 at year-end.
Shilstone's president, Bill Rowe, recognizes the need to take action to improve the company's liquidity position. He has hired Amy Cooper, an experienced cash manager, to assess the company's situation and make recommendations for improvement. Cooper has met with Jennifer Adams, Shilstone's controller, and has gathered the following facts:
• Shilstone's products have an average contribution margin of 30%.
• Shilstone is operating at slightly less than full capacity.
• Shilstone's current credit terms are 2/12, net 45, which is in line with industry standards.
• Late notices are sent out monthly on all past due accounts, with a follow-up telephone call to delinquent accounts in excess of $8,000.
• Delinquent accounts are sent to a collection agency when they become 12 months overdue.
Based on her experience and her analysis of Shilstone's data, Cooper has classified Shilstone's customers into eight categories based on the likelihood of their accounts becoming uncollectible.
She has implemented the following changes in Shilstone's credit policies to improve cash flow.
Cooper believes these changes will reduce bad debts to between 1 and 1.5% of sales.
• New credit terms of 2/10, net 30 will be applied to all accounts in risk categories 1 through
5. Cooper expects these customers to accept this change without issue. The overall effect of the change should be improved accounts receivable turnover and reduced bad debts.
• Customers in risk categories 6 and 7 will be subject to stricter credit terms, such as cash on delivery. Sales to customers in risk category 8 will have to be paid in advance. While Cooper acknowledges that Shilstone will lose some sales to customers in these categories, she believes the lost sales will be concentrated in the high-risk category.
• Collection efforts will be increased to ensure better compliance with the new credit terms.
Follow-up telephone calls will be made to all delinquent accounts in excess of $2,000.
Accounts that are nine months overdue will be turned over to a collection agency.
Jennifer Adams is responsible for extending credit to customers and for establishing the guidelines under which the manufacturer's representatives operate. She has often relaxed the company's credit terms to meet the needs of various customers, and over time she has developed a close relationship with many of the larger customers. After reviewing Amy Cooper's suggested changes, Adams has some concerns about the effect of the new policies on some of those customers, and by extension, on Shilstone's sales. She has performed her own customer risk analysis and concluded that some of Cooper's risk classifications are inappropriate. In her view, some of the larger customers are better business risks than indicated in Cooper's analysis.
Adams has concluded that following the new policies would reduce sales by more than Cooper estimates, leading to idle manufacturing capacity. She has decided not to share her findings with Rowe or Cooper. Instead, she will continue to use her discretion in relaxing the company's credit policies, particularly as they affect larger customers.
Required
a. What are the probable effects of the new credit policies on Shilstone's liquidity position?
b. Refer to the IMA's Statement of Ethical Professional Practice in Exhibit 1-8. Evaluate Jennifer Adams's decision not to fully comply with the changes in credit and collection policies implemented by Amy Cooper. Refer to specific standards when making your evaluation.
c. How would you recommend that Jennifer Adams handle her disagreement with Cooper's policies?
d. Assume it is December 30, and Adams is doing a preliminary review of the company's year-end balance sheet. It appears that the current ratio will be between 2.0 and 2.1, which would likely violate the company's debt covenants. Adams knows that one of her large customers, who happens to be a category 8 risk and is teetering on the verge of bankruptcy, is trying to get enough cash together to place a significant order with Shilstone. If she relaxes the new credit policies and allows the customer to purchase on credit, the resulting account receivable will push the current ratio over the required 2.1 level, preventing Shilstone from defaulting on its bank loan. Should Adams approve the sale? Why or why not? Refer to the IMA's Statement of Ethical Professional Practice in making your argument.