Harborline Instruments: Four Unresolved Matters at Year-End
Harborline Instruments, a calendar-year public company, is finalizing its December 31, 20X5 financial statements, expected to be issued March 12, 20X6. Draft pre-tax income is $22.0 million; the audit committee treats any pre-tax item above $1.0 million as material. Four matters are unresolved. (1) A customer owing $2.4 million at year-end had announced on November 20, 20X5 that it lost its largest contract; the balance was 60 days past due with only $0.2 million reserved. On January 27, 20X6 the customer filed Chapter 7. (2) A product-liability suit is accrued at $1.5 million, counsel's best estimate in a $1.0 to $4.0 million range; it settled for $6.0 million on February 14, 20X6. (3) A February 5, 20X6 fire destroyed an uninsured warehouse carried at $7.0 million; $5.0 million of insurance recovery is expected. (4) On February 10, 20X6 the controller found that a $3.0 million December shipment booked as revenue (35% margin) shipped FOB destination and arrived January 4, 20X6.
1. Classify each of the four matters as a recognized subsequent event, a nonrecognized subsequent event, or an error, and state the dollar adjustment to 20X5 pre-tax income, if any.
Read the worked answer
Matter (1) - Recognized subsequent event; adjust $2.2 million. The bankruptcy filing occurred after year-end, but it confirms a condition that existed at December 31: the November 20 contract loss, the 60-day delinquency, and the unsecured position. The receivable was already impaired at the balance sheet date; the filing simply resolves the uncertainty. Record an additional allowance of $2.4M - $0.2M = $2.2M.
Matter (2) - Recognized subsequent event; adjust $4.5 million. A settlement reached before the statements are issued provides evidence of the liability that existed at year-end. The accrual moves from the $1.5M best estimate to the $6.0M settlement amount: additional expense $4.5M. The fact that the original accrual was a reasonable point in the range does not prevent adjustment - the settlement is better evidence.
Matter (3) - Nonrecognized subsequent event; no adjustment. The fire is a condition that arose after December 31. No 20X5 expense; disclose the event and an estimate of the financial effect (approximately $2.0M net of the expected $5.0M recovery against the $7.0M carrying amount).
Matter (4) - Error in the draft statements; adjust $1.05 million. Title did not transfer until January 4, so the December sale failed the revenue criteria. This is not a subsequent event at all - it is a cutoff error discovered before issuance. Reverse $3.0M of revenue and $1.95M of cost of sales: gross profit overstated by $1.05M.
2. Compute the aggregate effect of the required adjustments on 20X5 pre-tax income, assess materiality, and state where each item should be presented in the income statement.
Read the worked answer
Aggregate effect on pre-tax income
| Item | Adjustment |
|---|---|
| (1) Additional allowance | $(2.20)M |
| (2) Litigation accrual | $(4.50)M |
| (3) Fire | $0.00M |
| (4) Revenue reversal, net of COGS | $(1.05)M |
| Total | $(7.75)M |
Revised pre-tax income: $22.0M - $7.75M = $14.25M, a 35% reduction.
Materiality. Every item except the fire exceeds the $1.0M threshold individually, and the aggregate is roughly one-third of pre-tax income - clearly material. Even the $1.05M cutoff error, which is the smallest adjusting item, cannot be waived because it is an error, and errors are evaluated on their own and in the aggregate, not offset against other misstatements.
Presentation.
- (1) Bad debt expense within selling, general and administrative expense (or a separate credit-loss line if the entity presents one).
- (2) Litigation expense in operating expenses; disclose the nature of the claim.
- (4) Reduce revenue and cost of sales in their normal line items; restore $1.95M of inventory and remove $3.0M of receivables.
- (3) Footnote only; consider a separate caption if the loss is disclosed as an unusual or infrequently occurring item in 20X6.
One further point worth flagging: because the aggregate is material, a previously issued set of statements containing these amounts would have required a prior-period restatement had the error been found after issuance.
3. Assume instead that Harborline is a nonpublic company whose statements are 'available to be issued' on March 12, 20X6 but are not actually issued until April 20, 20X6. A customer owing $1.8 million files for bankruptcy on March 30, 20X6. Is that event within the evaluation period, and does it change your treatment of the February 14 litigation settlement?
Read the worked answer
Evaluation period ends when the statements are available to be issued. For a nonpublic entity, subsequent events are evaluated through the date the financial statements are available to be issued - here, March 12, 20X6 - not the date they are physically issued. That date is disclosed. The March 30 bankruptcy therefore falls outside the evaluation period and neither recognition nor the ordinary subsequent-events disclosure is required.
The February 14 settlement falls inside the period (before March 12) and remains an adjusting event worth $4.5M.
Complication to raise with the auditors. Even though March 30 is outside the window, if that bankruptcy reveals that the December 31 receivable was not recoverable - that is, it is evidence of a condition existing at year-end - the company faces a subsequent discovery of facts that existed at the date of the auditor's report. The practical response is to determine whether the statements are materially misleading as available to be issued and, if so, revise them. This is a different mechanism from the subsequent-events evaluation period, and the distinction is the point: the window closes, but the obligation not to distribute known-materially-misleading statements does not.