Bobek Industries has recently reported steadily increasing income. The company reported income of €20,000 in 2019, €25,000 in 2020, and €30,000 in 2021. A number of market analysts have recommended that investors buy Bobek shares because the analysts expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2022, 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 a €7,000 warranty accrual this year, Bobek 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 2022 and 2023 and that total warranty expense over the 2-year period is €10,000. What is the effect of the proposed accounting in 2022? In 2023?

c. What is the appropriate accounting in this situation?