Background

Cathy Thomas is the controller of a medium sized division of a Fortune 500 publicly traded company. The company has a December 31 year end and the auditors will be there to perform the audit beginning January 28th. Prior to appointment to her current position approximately two years ago, Cathy worked for the corporate accounting staff at headquarters. The company has a reputation for promoting its outstanding performers while marginal performers are counseled out (i.e. fired). Cathy hopes to spend another year or so in her current position, and then be promoted to a larger division with more visibility and responsibility. Promotions are typically based upon recommendations of division management, but must receive concurrence of functional heads at corporate headquarters (for controller positions, the Senior VP and Controller of the company). The division president strongly encourages division management personnel to be team players; those who fail to demonstrate team behavior are rated negatively in performance evaluations.

Headquarters management expects its divisions to reach their respective earnings targets each year and has removed presidents of divisions for failing to meet targets in three consecutive years. Cathys division reached its earnings target for the first three quarters of the current year after failing to achieve targeted earnings the last two years. Last week, the division president indicated to the company CEO that the division is forecasting that it will most likely reach its earnings target in the fourth quarter and for the full year. Divisional management bonuses are projected to be 20% of her base salary. The divisional management is optimistic about the prospect of earning long awaited bonuses.

Cathys Background Cathys base salary before bonus is $100,000. Cathy earned her undergraduate degree in 2005. She went back to school and earned her Masters in Accountancy in 2009. She still has significant graduate school loans to pay and has incurred $20,000 of credit card debt. She also recently purchased a home and has a monthly mortgage payment of $1,600 plus a monthly car payment of $400. Cathy is hoping the expected bonus will cover her outstanding credit card debt since she has no other funds available to pay off her debt.

Adjustments

Four accounts remain to be considered for adjustment before divisional earnings are finalized for the fourth quarter and the year. Bonus calculations will be made after earnings are finalized. The four accounts and related considerations are as follows (all amounts are after tax effects):

1. During the year end physical inventory, approximately $200,000 of raw material was identified as probably unusable in normal production before its shelf life would expire. Discussions with the division Purchasing Manager reveal it is possible that $50,000 of the raw material could be sold to another company. The division Purchasing Manager contacted the other company who indicated a 60% chance it could use the $50,000 of material. The division Purchasing Manager promised to contact other companies about buying the remaining $150,000 of material.

2. A former manager level employee sued the division for $500,000 for age discrimination after being dismissed in a downsizing. In two different discussions with division legal counsel, the former employee offered to settle the lawsuit for $150,000 and later at $150,000 plus $50,000 in legal fees. Division legal counsel is still considering the settlement but it is not optimistic about the division prevailing in the lawsuit. However, division legal counsel indicated that the trial does not occur for six months, and the legal system provides a series of appeals if the division loses. Therefore, it could be several years before the outcome is ultimately known.

3. The division received an invoice for $300,000 from a consulting firm relating to work performed on a proposed new product. The invoice relates to work completed in the most recent quarter, but the division Research & Development (R & D) VP indicates that the invoice contains a significant overcharge based upon rate discussions held with the consulting firm project manager over lunch last week. Because the invoice is in dispute, the R&D VP requests that Cathy delay recording the invoice until he can resolve the amount with the consulting firm representative. The R&D VP believes he can negotiate a $175,000 discount and that the consulting firm will rescind the invoice until the matter is resolved.

4. The division has a $200,000, 5% note receivable from a customer who has, for the last ten years, purchased large volumes of the divisions products. The VP of Sales indicates that the customer is currently experiencing cashflow problems and recommends an extension/restructuring be granted for the note. Without the restructuring , the customer would be forced to default, and the division wou ld likely only recover 75% of the amount sold through repossession of the products. The VP of Sales also believes that if the extension is not granted then upon recovery from its cash difficulties the customer would begin to purchase its future product needs from competitors of the division. However, it is too early to tell whether the customers financial difficulties will be resolved or will worsen. The Sales VP believes that the division president would likely approve an extension/restructuring of the note.

REQUIREMENTS:

You are to assume the role of Cathy Thomas, the controller, who is charged with the responsibility of developing the estimates and presenting her proposal to the division president. Your group will make the necessary accounting adjustments for the above situations based upon the information provided. You should consult the codification for guidance for each situation also making sure you take materiality into account. The divisions preliminary results for the fourth quarter reveal after tax earnings of $10,400,000 vs. a target of $10 million. Complete the table below ,providing an estimate of the adjustments that the division controller would record in the fourth quarter:

Preliminary Earnings $10,400,000

Inventory Reserve __________

Litigation Liability __________

Accrued Consulting __________

Note Receivable Restructuring __________

Total Adjustments ___________

Division Net Earnings After Adjustments ___________

For each adjustment fully document the rationale for your conclusion including any authoritative guidance you found.