Trombly Inc. has recently reported steadily increasing income. Income reported in 2014 was $20,000, in 2015 was $25,000, and in 2016 was $30,000. Market analysts have recommended that investors buy Trombly stock because they expect that income will continue to increase. As Trombly’s 2017 fiscal year end approaches, results appear to be good but warranty expense has not yet been recorded.
Based on prior experience, 2017 warranty expense should be around $5,000, but some managers have approached the controller to suggest recording a larger, more conservative warranty expense this year. Income before warranty expense is $43,000. By recording a $7,000 warranty accrual this year, Trombly could report an increase in income for this year and still be in a position to cover its warranty costs in future years.
(a) Explain what is meant by 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 expected to be $10,000. What is the effect of the proposed accounting in 2017? What is the effect of the proposed accounting in 2018?
(c) What is the appropriate accounting in this situation?
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