RWP$8-8($Algo$)$ Earnings Management Case $-$

$1$

points

eBook

References

Quattro Technologies, a hydraulic manufacturer in the aeronautics industry, has reported steadily increasing net income over the past few years. The company reported net income of $$125$ million in $2022$ and $$145$ million in $2023.$ The stock is receiving increasing analyst attention because many investors expect the steady growth in net income to continue well into the future.

One of the factors increasing sales is the superior warranty Quattro offers. Based on experience, warranty expense in $2024$ should be around $$40$ million. However, in a recent executive meeting, it was suggested that the CFO report a larger, more conservative estimate of warranty expense of $$50$ million this year.

Required:

Can Quattro use warranty expense to manage its reported anfount of net income?

Assume net income before warranty expense is $$215$ million in $2024$ and $$215$ million in $2025,$ and total warranty expense over the two years is $$80$ million. Calculate net income after warranty expense based on the suggestion in the executive meeting to report $$50$ million in warranty expense in $2024.$ Calculate net income after warranty expense in $2025.$

Does reporting warranty expense of $$50$ million in $2024$ and $$30$ million in $2025$ produce a steadier growth in net income than does reporting $$40$ million in each year?