It is recommended that Grace, Inc. adopt the conservative approach to its warranty expense for 2001 and 2002 in order to reflect accurately the company's financial position.
Warranty expense is a subjective matter open to several interpretations, and an aggressive approach has been proposed which would help the company show an increase in income during the 2001 to 2002 period (see attachment). The total warranty expense for these two years would be the same amount ($10,000) regardless of whether the conservative or aggressive approach is used. However, the aggressive approach would be a deviation in the company's own procedures that have been in place in recent years and does not address the underlying problem, which is that revenues are expected to stay flat from 2001 to 2002. Because of this, it could be construed that the management of Grace was intentionally trying to mislead investors and other stakeholders into believing that the company's performance was better than a more conservative--and the company's own traditional--approach would indicate. The Securities and Exchange Commission has been particularly watchful of discretionary items such as warranty expense and other "cookie jar" reserves since the Enron and WorldCom scandals of the early 2000s, and is particularly suspicious when a company deviates from its own reporting practices.
EXPECTATIONS AND FORECASTS AT GRACE, INC.
Currently, sales are expected to remain steady for 2001 and 2002; the assumption is that COGS and related items will also remain steady, so income, which has increased $5,000 each year from 1998 to 2001, is expected to remain steady from 2001 to 2002. This assumes that warranty expense also remains steady at $5,000, which is the company's own internal forecast. Total warranty expense for 2001 and 2002 is $10,000, and some senior managers have suggested taking an additional $3,000 in 2001 to boost warranty expense to $8,000 in 2001 with only...