Grace Inc. has recently reported steadily increasing income. The company reported income of $20,000 in 2005, $25,000 in 2006, and $30,000 in 2007. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Grace is approaching the end of its fiscal year in 2008, and it again appears to be a good year. However, it has not yet recorded warranty expense. Based on prior experience, this year’s warranty expense should be around $5,000, but some managers have approached the controller to suggest 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 increase in income for this year and still be in a position to cover its warranty costs in future years.

Instructions
(a) What is earnings management?
(b) Assume income before warranty expense is $43,000 for both 2008 and 2009 and that total warranty expense over the 2-year period is $10,000. What is the effect of the proposed accounting in 2008? In 2009?
(c) What is the appropriate accounting in this situation?