The Transmission Shop was the largest company in Ontario specializing in rebuilding automobile transmissions. Every transmission rebuilt by the business was covered by a six-month warranty. The owner, Ron Wood, was meeting with his accountant to go over the yearly financial statements. In reviewing the balance sheet, Ron became puzzled by the large amount of current liabilities being reported, so he asked his accountant to explain them. The accountant said that most of the current liabilities were the result of accruals, such as the estimated warranty payable, some additional wages payable, and interest accrued on the note owed to the bank. The employees were not actually paid until the first week of the new year, so some of their wages had to be recorded and properly matched against revenues in the current period. Also, several months of interest expense had to be accrued on a bank loan, but the largest amount of the accrued liabilities was due to the estimated warranty expense. Ron asked whether the wages payable and the interest payable could be removed because they would be paid off shortly after the year ended. The accountant stated that accrued liabilities had to be properly recognized in the current accounting period, and, thus, they could not be removed. Ron agreed but then asked about the large accrued liability based upon the estimated warranty amounts. Again, the accountant stated that in previous years actual warranty cost had been about 5% of the total sales and, therefore, in the current year the estimate was accrued at 5%. Ron then informed the accountant that a new conditioning lubricant had been added to each transmission rebuilt, which dramatically reduced the amount of rebuilt transmissions being returned under warranty. As a result, Ron strongly felt that the warranty estimate should be reduced to only 2% of total sales and, thereby, the accrued warranty liability and related expense would also be reduced. The accountant argued that the only reason Ron wanted to reduce the estimated percentage was to improve the financial statements, which would be unethical and inappropriate.

Requirements

1. What is the impact of accrued liabilities on the financial statements? Should the accrued liabilities for wages and interest payable be removed from the balance sheet?

2. Does Ron have a valid reason for wanting to reduce the estimated warranty liability? Are the concerns expressed by the accountant valid?

3. What ethical issues are involved?