(Creating hidden reserves, LO 4) The president of Remo Ltd. (Remo) wants to use hidden reserves to “save” income for a year when the company is not performing very well. To accomplish this objective, the president instructed the accounting department to over-estimate the bad debt expense each year. Instead of using the historical norm of 1.5% of credit sales, the president suggested using 1.75% of credit sales. Remo commenced this “policy” in 2004 and it has continued through 2008, a period in which Remo has been very successful. The following information about Remo is available:

The balance in Remo’s Allowance for Uncollectable Accounts on January 1, 2004 was $31,500.

Required:

a. Prepare a table that shows:
i. Remo’s bad debt expense from 2004 through 2008 using the 1.5% rate.
li. Remo’s bad debt expense from 2004 through 2008 using the 1.75% rate.
ul. The Allowance for Uncollectable Accounts at the end of each year using each of the estimates.
iv. Net income for each year using each of the two estimates.

b. How could the president of Remo justify using the 1.75% rate for estimating bad debts? :

c. In 2009 Remo’s net income fell slightly and the president was concerned about a negative response from shareholders and creditors. He was especially concerned that Remo was planning to approach new equity investors to invest in Remo.
Credit sales during 2009 were $5,191,000 and net income, excluding the bad debt expense, for the year was $441,410. At this point the president “recognized” the error that had been made over the previous five years and decided it was time to correct it. The president instructed the accounting department to reduce the balance in the Allowance account to the level that would have existed had Remo used 1.5% of credit sales as the basis of calculating the bad debt expense each year.
i. What journal entry would be prepared to reduce the balance in the Allowance account to the desired level?
ii. What would be the effect on net income of making this journal entry?

d. Why are hidden reserves a serious problem that undermines the integrity and usefulness of accounting information?

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2004 2005 2006 2007 2008 Credit sales Net income, excluding the bad $2,527,000 $3,158,750 $3,632,563 $4,286,424 $4,929,387 232,484 315,875 345,093 398,637 443,645 debt expense Accounts receivable write-offs 31,500 37,905 47,381 54,488 64,296