CA 4-2, p. 190 Instructions Indicate the deficiencies in the income statement pr

Question

CA 4-2, p. 190

Instructions

Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a single-step income statement.

CA4-2 GROUPWORK (Earnings Management) Bobek Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2014, $25,000 in 2015, and $30,000 in 2016. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2017, and it again appears to be a good year. However, it has not yet recorded warranty expense.

Based on prior experience, this year's warranty expense should be around $5,000, but some managers have approached the controller to suggest a larger, more conservative warranty expense should be recorded this year. Income before warranty expense is $43,000. Specifically, by recording a $7,000 warranty accrual this year, Bobek could report an increase in income for this year and still be in a position to cover its warranty costs in future years.

Instructions

(a)What is earnings management?

(b)Assume income before warranty expense is $43,000 for both 2017 and 2018 and that total warranty expense over the 2-year period is $10,000. What is the effect of the proposed accounting in 2017? In 2018?

(c)What is the appropriate accounting in this situation?

O'MALLEY CORPORATION
INCOME STATEMENT Sales revenue $850,000 Dividends 32,300 Gain on recovery of insurance proceeds from earthquake loss 38,500 920,800 Less:   Selling expenses $101,100   Cost of goods sold 510,000   Advertising expense 13,700   Loss on obsolescence of inventories 34,000   Loss on discontinued operations 48,600   Administrative expense 73,400 780,800 Income before income tax 140,000 Income tax 56,000 Net income $84,000

Explanation / Answer

O'MALLEY CORPORATION Single-Step INCOME STATEMENT Revenues & Gains Sales revenue 850000 Dividends 32,300 Gain on recovery of insurance proceeds from earthquake loss 38,500 Total Revenues &gains 920,800 Expenses & losses   Cost of goods sold 510,000   Selling expenses 101100   Administrative expense 73,400   Advertising expense 13,700   Loss on obsolescence of inventories 34,000 Total Expenses & losses 732,200 Income from continuing operations 188,600   Loss on discontinued operations 48,600 Income before income tax 140,000 Income tax 56,000 Net income 84000 a.Earnings management is deliberately managing higher earnings for a variety of reasons such as for maintaining the company's prestige & previous record in the eyes of the investing public so as to maintain/push up   the stock prices , or for purposes of higher incentives & bonus to managers that increase based on the increased profits. Effect of the proposed accounting in 2017 Debit   Warranty Expense      7000                       (decreases income by 7000-ie. 36000) Credit   Warranty Liability                     7000        (Increases current laibility by 7000 ) Effect of the proposed accounting in 2018 Debit   Warranty Expense      3000                       (decreases income by 3000-ie. 40000) Credit   Warranty Liability                     3000        (Increases current laibility by 3000 ) c. Appropriate accounting will be: In both 2017 & 2018 Debit   Warranty Expense      5000                       (decreases income by 5000-ie. 38000) Credit   Warranty Liability                     5000        (Increases current laibility by 5000 )

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