A public company is preparing its annual financial statements. Which of the following items would typically be disclosed as a subsequent event that requires disclosure but not adjustment to the financial statements?
- AIssuance of a significant amount of new common stock after the balance sheet date but before financial statements are issued.
- BDiscovery of a material error in the calculation of inventory at year-end.
- CBankruptcy of a major customer due to deteriorating financial condition that existed at year-end.
- DSettlement of litigation with a gain, where the outcome was probable and estimable before year-end.
Show answer & explanationAnswer & explanation
Correct answer: A. Issuance of a significant amount of new common stock after the balance sheet date but before financial statements are issued.
Subsequent events are events that occur after the balance sheet date but before financial statements are issued. Type I (recognized) subsequent events provide additional evidence about conditions that existed at the balance sheet date and require adjustment. Type II (non-recognized) subsequent events provide evidence about conditions that did not exist at the balance sheet date but arose after that date and require disclosure. The issuance of new common stock is a Type II event, as the condition (issuance) did not exist at year-end.
Why the other options are wrong
- B. This is a Type I subsequent event, as the error relates to inventory valuation at year-end, requiring adjustment.
- C. The bankruptcy of a customer due to conditions existing at year-end is a Type I subsequent event, providing evidence about the collectibility of receivables at year-end, thus requiring adjustment.
- D. This is a Type I subsequent event, as the condition (litigation outcome) existed at year-end, requiring adjustment to the financial statements.
Subsequent Events (Type I vs. Type II)
Subsequent events are events occurring after the balance sheet date but before financial statements are issued. Type I events provide evidence of conditions existing at the balance sheet date and require adjustment. Type II events provide evidence of conditions arising after the balance sheet date and require disclosure.
- Type I: Adjust financial statements (e.g., litigation settlement, uncollectible receivables, inventory valuation).
- Type II: Disclose in notes (e.g., stock issuance, bond issuance, business combination, casualty losses).
- Management is responsible for identifying subsequent events.
- Period ends when financial statements are issued or available to be issued.
Memory trick: Conditions existing? Adjust. Conditions new? Disclose.