Chapter 8, Problem 8.8APEM

Earnings Management

Quattro Technologies, a hydraulic manufacturer in the aeronautics industry, has reported steadily increasing earnings over the past few wars. The company reported net income of $120 million in 2016 and $140 million in 2017. The stock is receiving increasing analyst attention because many investors expect the steady earnings growth to continue well into the future.

One of the factors increasing sales is the superior warranty Quattro offers. Based on experience, warranty expense in 2018 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. Income before warranty expense in 2018 is $210 million. By recording a warranty expense of $50 million this year, Quattro could maintain its steady earnings growth and be in a better position to maintain earnings growth again next year.

Required:

1.    Can Quattro use warranty expense to manage its earnings? How?

  2.    Assume income before warranty expense is $210 million in 2018 and 2019, and total warranty expense over the two wars is $80 million. What is the impact of the executive meeting suggestion on income in 2018? In 2019?

  3.    Is the executive meeting suggestion ethical? What would you do if you were the CFO?