Question

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

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?

Answer 1

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 )