Auditors have their own interests they must consider

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b.Auditors have their own interests. They must consider factors affecting their own well-being. One item that could adversely affect auditors' well-being is being the defendant in a lawsuit. If the auditors did not require an adjustment for the Litzenberger account, and Litzenberger was subsequently unable to pay its debt, users of Hadley's financial statements could sue the auditors for any losses incurred. Conservatism, which states "when in doubt, understate rather than overstate," applies to this situation. Since the auditors are uncertain as to whether Hadley Company will ever collect the money from Litzenberger, the auditors would prefer to understate Hadley Company's financial health rather than overstate it.P6–7Concluded
c.While it is true that Litzenberger is still operating, Hadley's CFO is ignoring the revenue recognition principle and the matching principle. Under the revenue recognition principle, revenue should not be recognized if post-sales costs can not be adequately estimated (subject to materiality). In this case, the actual bad debt cost associated with Litzenberger will not occur until a subsequent period. However, if this cost cannot be adequately estimated, Hadley Company should not even recognize the revenue from the sale to Litzenberger. Assume that Hadley Company can adequately estimate the bad debt cost. In this case Hadley Company is allowed to recognize the revenue. But under the matching principle, all costs associated with generating revenue should be matched against that revenue. Hence, any costs associated with making a sale, whether incurred in the current period or in subsequent periods, should be recorded in the period of the sale. Since the bad debt cost is associated with generating revenue, Hadley Company should record the bad debt cost in the current period as an expense.P6–8a.The effect of the auditors’ findings on 2011 Fees Earned, Accounts Receivable, Allowance for Doubtful Accounts, current ratio, working capital, and net income can be determined as follows.Fees Earned:Fees Earned would decrease from $240,000 to $230,000.Accounts Receivable:Accounts Receivable would decrease from $68,000 to $58,000.Allowance for Doubtful Accounts:This account should have a balance equal to 10% of the new Accounts Receivable balance. The correct balance would be $5,800, or an increase of $2,400.Current Ratio:The current ratio before the auditors’ findings was 1.62 ($105,000 ÷ $65,000). Current assets after adjusting for the auditors’ findings would be $92,600 ($105,000 – $10,000 decrease in Accounts Receivable – $2,400 increase in Allowance for Doubtful Accounts). Current Liabilities would be unaffected by the auditors’ findings. Thus, the new current ratio would be 1.42 ($92,600 ÷ $65,000).Working Capital:Working capital would decrease from $40,000 ($105,000 – $65,000) to $27,600 ($92,600 – $65,000).Net Income:Net income would decrease by the reduction in Fees Earned of $10,000 and by the increase in Bad Debt Charge of $2,400. The new net income would be $2,600.b.Prior to the auditors’ findings, Finley, Ltd. was in compliance with its debt covenants.

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