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Sarbanes Oxley Act & Accounts Receivable

written by: ciel s cantoria•edited by: Linda Richter•updated: 3/18/2015

Understand the relevance of the Sarbanes Oxley Act to Accounts Receivable, Bad Debts, Allowances for Doubtful Accounts, and the popular use of these items in financial misrepresentations. The accounts receivable of WorldCom are examples of accounting manipulations exposed by the SEC in 2001.

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    SEC - Sarbanes Oxley Act - Accounts Receivable -- WorldCom

    547px-Accounting cycle 

    In reading and interpreting financial data, there are certain accounts that require careful attention, as pointed out by the Sarbanes-Oxley Act. Accounts Receivable, Bad Debts, and Allowances for Doubtful Accounts are some of the accounts watched closely by the Securities and Exchange Commission in order to determine corporate compliance with the SOX Act.

    The Sarbanes Oxley Act is an offshoot of the numerous white collar crimes exposed in 2001, in which investors lost their confidence in the capital markets and financial reports.

    This article provides as an example the accounts receivable of WorldCom, which was the specific financial item looked into by the Securities and Exchange Commission (SEC). Further investigations led to the discovery of all other accounting manipulations being committed by WorldCom.

    Prior to our delving into the accounting anomalies that were performed by WorldCom, the succeeding section provides a brief informational background on the proper accounting for Accounts Receivable. This is for the benefit of those with limited knowledge on how Accounts Receivable are treated, as far as their valuations in the financial statements are concerned.

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    Basic Accounting Procedures in Handling Accounts Receivable

    459px-Basic Credit Default Swap (CDS) diagram.svg 

    A company that extends credit to its customers as a general practice records the sales by creating a subsidiary ledger for every customer’s account. The related accounting entries in the general ledger books represent periodic totals of sales made on credit.

    1. Basically, there is no cash received; hence the item Accounts Receivable will be debited and the corresponding credit will be Sales on Credit. This is to readily distinguish the total amount of sales on credit against the COD sales.

    2. It is important for companies to have sound credit policies before granting sales on credit to customers. Otherwise, recognizing revenues without actually adding cash to the company’s coffers spells disaster in the long run.

    3. However, even with sound credit policies, there are instances when customers fail to honor their commitments and risk tarnishing their credit reputations by defaulting on payments. As a general rule, a matter of 180 days after the account has become past due is reasonable time in which defaulted accounts are considered as bad debts.

    4. There are two reasons why it is considered to be proper accounting procedure to recognize as bad debts the defaulted accounts of more than 180 days. At this point, however, it should be clear to the reader that in recognizing a defaulted account as Bad Debt, collection efforts will still continue and that all possible means of collection should still be applied.

    Under IRS Tax rules - All sales revenues recognized as income for the year shall be taxed in the same year they are recognized whether actually earned or unearned. Interests earned from these Accounts Receivable-Sales are accrued and recognized as additional income for the year.

    Under SEC rules - All income reported in the SEC financial report should reflect only the income that was actually earned at the time of reporting. Sales on credits and accruals therefore do not qualify as actual revenues.

    5. Thus, the defaulted accounts are technically written-off as receivables accounts, by setting-up an Accounts Receivable contra asset called Allowance for Doubtful Accounts (ADA) and by debiting the Bad Debts expense account. Readers may read a separate article on how to set up these Allowances for Doubtful Accounts through the article entitled, Allowance for Doubtful Accounts: Examples and Explanations.

    While under the ADA, the defaulted accounts are not yet treated as outright deduction of the Accounts Receivable balance but are merely provided as valuation estimates in order to present the real net worth of a company.

    6. Balance Sheet Presentation of Accounts Receivable:

    Accounts Receivable – Sales or Trade ----------xyz

    Less: Allowance for Doubtful Accounts ------- xyz

    Net Book Value –Accounts Receivable Sales or Trade --- xyz

    7. In recognizing the default as Bad Debts expense, this entry will have an offsetting effect against the amount included as Sales on Credit. In addition, all accrual of interest will cease and could be reversed since the entries are mere accrual or adjusting entries.

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    8. Company policies will dictate the reasonable amount of time and effort exhausted in collecting bad debts, which gives provisions on when defaulted accounts are to be actually written off in the books of the company.

    9. Usually, these bad debts are sold at a discount to collecting agents. They assume pseudo-ownership of uncollectible accounts and earn from the successful collection of the actual value plus the interests and penalty charges earned by the account. Once sold to a collecting agent, the originating company can actually write off the bad debts, since the collecting agent already paid for them, albeit at a discounted amount.

    10. Actual write-offs will be recorded by debiting the Allowance for Doubtful Accounts and crediting Accounts Receivable, thus reducing the actual balance of the latter account.

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    The Case of WorldCom and Its Unsound Accounting Practices

    Arthur Andersen Witnesses 

    WorldCom was heavily indebted as a result of acquisitions and projections of rapid growth. This was, of course, a corporate strategy to entice more investors to infuse their money into WorldCom. However, debts piled up, as Accounts Receivable could not be collected while sales projections did not materialize as expected.

    WorldCom resorted to manipulating its revenues by recording single sales transactions twice in its books. Operational expenses were not recognized as expenses for the year in accordance with matching principles but instead were capitalized. This, of course, bloated the company’s assets and lessened the expenses that should have reduced the income or should have otherwise resulted in losses in the company’s books.

    In addition, defaulted accounts receivable, already considered as dead accounts, were not recognized as bad debts but were allowed to remain as current assets of the company. Additional income was likewise recognized by the company as accrual of interest income continued. This bloated the company’s resources and income even further.

    However, the company’s creditors were already calling their loans amounting to $366 million. WorldCom's CEO Bernie Ebbers was bound to lose his majority ownership of the company once creditors moved in. The CEO’s remedy was to solicit a company loan for $366 million, which he would use to pay off creditors as if the money were coming from his personal funds. This then would bar the latter from gaining control of WorldCom, and CEO Ebbers would retain majority ownership of the company.

    Thus, WorldCom submitted a report to the Securities and Exchange Commission, which included the substantial amount of Accounts Receivable granted to CEO Ebbers. SEC examiners were not satisfied with the explanation offered by the company; hence a full-blown investigation was conducted by the agency. As a result, CEO Ebbers and WorldCom’s financial manipulation were exposed, and this led to the company’s bankruptcy. Millions of lives were affected--not only those of the investors but also those of the employees who lost their jobs.

    The accounting manipulations were simple and could have been detected under any ordinary system of internal control. The SEC investigations further revealed that the auditing firm of Arthur Andersen, who was also the auditing firm of Enron, played a major role in manipulating the financial statements of the company. The auditing firm’s participation included the destruction of accounting and auditing records that could shed light in establishing the total amount of fraud involved.

    Nevertheless, the SEC was able to establish as much as $11 billion in terms of improperly treated operating expenses that bloated the company’s revenues.

    These are now the surrounding facts that gave rise to the rules of the Sarbanes-Oxley Act for Accounts Receivable and other accounting and reporting regulations.

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    Synopsis of the Sarbanes-Oxley Act Guidelines for Financial Reports

    Under the Sarbanes-Oxley Act, financial accounting and reporting should observe the following guidelines:

    • The reports are accurate and do not contain or omit material amounts that will make the financial statements untrue and misleading.
    • The financial statements and the information contained therein present fairly the actual financial conditions of the company in all material aspects.
    • The officers who sign and attest to the veracity of financial reports submitted are also attesting that proper internal controls and review of the underlying financial data have been instituted, applied, and performed before said reports were submitted.
    • An independent auditing firm will confirm the company executive’s and officer’s attestations, by issuing a separate audit report that the financial statements present fairly the financial position and condition of the company. Otherwise, a qualified audit report will provide in detail the deficiencies, internal fraud, or changes in the company reporting policies and internal controls that create or can create a significant impact in the actual financial condition of the company.
    • In addition, the auditing firm who attests to the soundness of the financial reports and the internal controls implemented by the company does not render actuarial and financial consulting services to the company audited.
    • Executive officers and directors of the board shall in no way have existing loans with the company, even if said loan is offered by the Board. That cannot occur unless the company’s business is involved in lending out funds and the loans are granted to executive officers and directors under the same rules and conditions by which the loans are extended to its customers.

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    Under the Sarbanes-Oxley Act, Accounts Receivable should be given proper valuation estimates or properly brought to the actual value through the recognition of Bad Debts and setting-up of the Allowance for Doubtful Accounts, in order to present the company’s actual sales and net worth.

    In addition, there should be proper review and internal control measures that provide counter-checking of this account's accuracy and veracity. Any discrepancy, deficiency, or internal fraud discovered and noted during the audit should be properly disclosed and reported to the SEC, especially if they will materially affect the actual financial condition of the company.

    Last, executive officers and directors are not allowed to take out loans or advances from a company in which they have partial ownership.

    These are now the relevant provisions of the Sarbanes Oxley-Act that Accounts Receivable accounting should observe.

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    Reference Materials and Image Credit Section


    Image Credits: