Accounting Ethics: Bad Debt Allowance and GAAP Compliance

Stakeholder Identification and the Core Decision

Chris faces two basic choices. The first is to increase the allowance for bad debts to account for the possibility that Ender will be unable to pay its obligations. The second is to make no adjustment for this possibility. Because the receivable is material, there will be meaningful consequences for the construction company if Ender cannot pay. Chris has an obligation to ensure that the company's financial statements accurately reflect its financial condition. A mitigating factor, however, is that Chris does not have direct factual evidence of Ender's financial situation — only hearsay, or "word on the street."

Several stakeholders are implicated in this decision. Chris and Laurent are stakeholders on a personal level, having discussed the situation directly. The construction company itself is the most significant stakeholder, and all of its internal constituents — employees, owners, and managers — are stakeholders in their own right. Suppliers and other business partners of the construction company are also affected. Because the company is not publicly traded, regulators are not stakeholders; however, if the allowance for bad debts affects taxes payable, the IRS would become one. Ender is a tangential stakeholder: whatever accounting decision Chris makes will likely never be known to Ender, and it will have no effect on Ender's ultimate ability to pay. The bank is also a stakeholder, given that the construction company is seeking a loan.

Why This Is Not a True Ethical Dilemma

This situation can be analyzed through multiple ethical frameworks, but before doing so it is important to establish a critical point: this is not an ethical dilemma in the strict sense — it is a legal obligation. Failing to adjust the allowance when there is good reason to do so is prohibited under FASB Topic 310. Specifically, paragraph 450-20-50-3 states that disclosure of a contingency is required "if there is at least a reasonable possibility that a loss or an additional loss may have been incurred" and an exposure to loss exists in excess of the amount already accrued. Given that the receivable is material, that the creditor's situation is widely understood to be precarious, and that the likelihood of payment is considered minimal by key decision-makers at the construction company, Chris is not weighing two ethically ambiguous options — he is deciding whether to comply with the law or break it.

This does not satisfy the criteria for an ethical dilemma. Society and the accounting profession are governed by laws, and in this case those laws are unambiguous. Violating them is a clear moral failing. There is no corresponding moral failing for obeying them. Our society does not accept utilitarian justifications as reasonable grounds for breaking laws. Even if it did, the argument that following Generally Accepted Accounting Principles (GAAP) constitutes a moral failing is thin, hypothetical, and contingent on outcomes so uncertain as to render the choice non-binary. Chris is not condemned to business failure by complying with GAAP. Because he is not forced to choose between two courses of action that each require a moral failing, he is not in an ethical dilemma by definition (McConnell, 2014).

Utilitarian Analysis

The following analysis is therefore theoretical only. From a utilitarian perspective, the outcome depends entirely on whether any omission would be discovered. If Chris were to avoid adjusting the allowance and were never caught, the theoretical benefits — accepting Laurent's argument at face value — might be significant and spread across many stakeholders, including the construction company's employees and suppliers. However, the realistic probability of such a deception going unnoticed is low, and any positive gains are contingent on Chris successfully concealing the fraud indefinitely.

Under the utilitarian standard of the greatest good for the greatest number, the outcomes for all stakeholders must be weighed — but not at face value. The relative importance of each stakeholder, the magnitude of their gains or losses, and the probability of each outcome must all factor into the calculus. It is here that the case for non-compliance collapses entirely.

If Ender does go out of business, the construction company will be required to undertake a full writedown of the receivable at that point. The same negative financial outcomes will occur regardless. Moreover, if Ender fails before the end of the fiscal year, the construction company will still be unable to secure the loan, because the lender will become aware of the situation. It will also become immediately apparent that the allowance adjustment should have been made and was not. The likelihood that an auditor, the lender, and other significant stakeholders would recognize that the books had been manipulated is high. Utilitarian calculus only favors non-compliance when the odds of avoiding detection are good — and in this case, they are not. There is also an established pattern for how much allowance is normally extended to Ender, making any deviation conspicuous. This is yet another reason why no genuine moral dilemma exists: there is no credible upside to breaking the law.

Conclusion and Recommended Course of Action

Insomuch as there is a decision to make, Chris must adjust the allowance for bad debts to reflect the likelihood that the material receivable from Ender will not be collected. This is required under the relevant provisions of Generally Accepted Accounting Principles, first and foremost. It is also consistent with universalist principles. Both the utilitarian and profit-maximization perspectives arrive at the same conclusion: the probability that the deception would go unnoticed is negligible, since Ender is likely to go bankrupt in any case, at which point a writedown will be forced. This also means that the hypothetical positive outcomes from the accounting fraud would never actually materialize. Where there is no plausible upside and a clear downside, no moral dilemma exists. Chris has nothing to lose by obeying the law. The company will simply need to find another solution to its goal of securing a loan — and it will have to do so regardless of what Chris decides, if Ender goes out of business before the end of the year.

Ultimately, Chris has only one defensible course of action, supported by all rational, legal, and ethical analysis. He is not being asked to break the law to save a life; he is being asked to break the law for a hypothetical benefit that is almost guaranteed never to materialize. Chris must adjust the allowance for bad debts to reflect Ender's current financial status, meaning the entire material receivable must be included in the allowance for the next quarter — unless Ender goes out of business first, at which point the matter becomes moot. This adjustment must be made prior to any loan application; to delay even until that point would constitute fraud.

References

FASB Topic 310. Retrieved September 29, 2015, from http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175821014426&blobheader=application/pdf

Mackey, J. (2005). Rethinking the social responsibility of business. Reason. Retrieved September 29, 2015, from https://reason.com/archives/2005/10/01/rethinking-the-social-responsi

McConnell, T. (2014). Moral dilemmas. Stanford Encyclopedia of Philosophy. Retrieved September 29, 2015, from http://plato.stanford.edu/entries/moral-dilemmas/