In recent years, Grace Inc. has reported steadily increasing income. The company reported income of $20,000 in 2017, $25,000 in 2018, and $30,000 in 2019. Several market analysts have recommended that investors buy Grace Inc. shares because they expect the steady growth in income to continue. Grace is approaching the end of its 2020 fiscal year, and it looks to be a good year once again.

However, it has not yet recorded warranty expense.

Based on prior experience, this year’s warranty expense should be around $5,000, but some members of top management have approached the controller to suggest that a larger, more conservative warranty expense should be recorded this year. Income before warranty expense is $43,000. Specifically, by recording an $8,000 warranty accrual this year, Grace could report an income increase for this year and still be in a position to cover its warranty costs in future years.

Instructions

a. What is earnings management?

b. What would be the effect of the proposed accounting in 2020? In 2021?

c. What is the appropriate accounting in this situation?

d. Digging Deeper Discuss the effect of the proposed accounting on a potential investor’s decision to invest in the company.