AlKhor Company has recently reported steadily increasing income. The company reported income of QAR 200,000 in 2012, QAR 250,000 in 2013, and QAR 300,000 in 2014. A number of market analysts have recommended that investors buy their shares because they expect the steady growth in income to continue. AlKhor is approaching the end of its fiscal year in 2015, 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 QAR 50,000, 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 QAR 430,000. Specifically, by recording a QAR 70,000 warranty accrual this year, AlKhor could report an increase in income for this year and still be in a position to cover its warranty costs in future years.
1. Is there an earnings management problem in the above case study? Explain the problem in details if any.
2. If the controller accepted to record a QAR 70,000 warranty expense in 2015, would this be counted as a violation to the generally accepted accounting principles? Identify and discuss the accounting principle that would be violated, if any.
3. Assume that the net income before warranty expense for each of 2015 and 2016 is QAR 430,000 and that total warranty expense over the 2-year period is QAR 100,000. What is the effect of the proposed accounting treatment on the income statements of 2015 and 2016?
4.Discuss the negative consequences that might be caused by the earnings management practices.