The SEC took action against Gateway Computer in 2001 because they believed that Gateway systematically understated their allowance for doubtful accounts to meet sales and earnings targets. This is essentially the way the alleged fraud took place:

• Gateway sold most of its computers over the Internet and had a strong credit department that approved sales.

• When sales dropped, management decided to go back to customers who had been rejected because of poor credit approval.

• During the first quarter, they went after the better of the "previously rejected" customers.

• As the need for more revenue and earnings remained, they continued down the list to include everyone.

• However, they did not change any of their estimates for the allowance for uncollectible accounts.

At the end of the process, the poor credit customers represented about 5% of total income, but the SEC alleged that the allowance account was understated by over $35 million, which amounted to approximately $0.07 per share. In essence, Gateway wanted to show it was doing well when the rest of the industry was doing badly.

Required

a. What is the requirement regarding proper valuation of the allowance for doubtful accounts? Does that requirement differ from account balances that are based on recording transactions as opposed to the allowance being an estimate? In other words, is more preciseness required on account balances that do not contain estimates?

b. What information should the company utilize in a system to make the estimate for the allowance for uncollectible accounts?

c. What evidence should the auditor gather to determine whether the client's estimate for the allowance for uncollectible accounts is fairly stated?

d. How should the expansion of sales to customers who had previously been rejected for credit affect the estimate of the allowance for doubtful accounts?

e. How important are current economic conditions to the process of making an estimate for the allowance for doubtful accounts? Explain.