The economics of conservatism
Joe McGuire is a CPA who has recently completed the audit of Nelson Repairs, Inc. The audited balance sheet and income statement follow:
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Balance Sheet |
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Current Assets |
$60,000 |
Liabilities |
$80,000 |
|
Long-Term assets |
140,000 |
Shareholders’ equity |
120,000 |
|
Total assets |
$200,000 |
Total Libilities and Shareholders’ equity |
$200,000 |
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Income Statement |
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|
Sales |
$160 |
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Expense |
$130 |
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Net income |
$30,000 |
During his examination, Joe learned that a lawsuit is soon to be filed against Nelson. The lawsuit accuses Nelson of negligence and asks for damages of $60,000 over and above the insurance. If Nelson were to lose the lawsuit, the future of the business would be in jeopardy. However, as the lawyers described it to Joe, the probability that Nelson will lose the lawsuit is very low, approximately 20 percent.
Joe is unsure about whether he should require Nelson to disclose the lawsuit on the financial statements. The president of Nelson does not want it disclosed because he believes that the disclosure would cause undue concern among the company”s shareholders. Joe does not want to ignore the president”s request because Nelson is his most important client. On the other hand, Joe knows that if he does not require disclosure, and Nelson loses the lawsuit, he may be legally liable for the losses of the shareholders. Joe constructed the following framework to help him make his decision.
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Lawsuit Outcome |
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Decision |
Win (80%) |
Lose (20%) |
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Require disclosure |
Error 1 |
Correct decision |
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Do not require disclosere |
Correct decision |
Error 2 |
REQUIRED:
a. Study Joe”s framework, and note that he can choose to require or not to require disclosure. Requiring disclosure and winning the lawsuit gives rise to Error 1. Not requiring disclosure and losing the lawsuit gives rise to Error 2. Comment on the costs that Joe would incur from each of these two errors. Which of the two errors would be more costly? Which of the two outcomes (winning or losing the suit) is more likely to occur?
b. Suppose that Joe estimates that the cost of Error 1 is $10,000 and the cost of Error 2 is $50,000. Ignoring the costs and benefits of correct decisions, should Joe choose to require disclosure?
c. Explain the concept of conservatism in terms of Joe”s framework.