A publicly traded company, Newton Corp., is preparing its financial statements for the year ended December 31, Year 1. On January 15, Year 2, a major customer, whose accounts receivable balance was $1,500,000 at December 31, Year 1, filed for bankruptcy due to unforeseen circumstances that arose in early January Year 2. Newton Corp. had no indication of the customer's financial distress prior to Year 2. How should Newton Corp. account for this event?
- AAdjust the December 31, Year 1 financial statements by recording an allowance for doubtful accounts of $1,500,000.
- BDo nothing, as the event occurred after the balance sheet date and is not material.
- CDisclose the event in the notes to the December 31, Year 1 financial statements but do not adjust the financial statements.
- DAdjust the December 31, Year 1 financial statements by recording a direct write-off of the $1,500,000 receivable.
Show answer & explanationAnswer & explanation
Correct answer: C. Disclose the event in the notes to the December 31, Year 1 financial statements but do not adjust the financial statements.
This event is a Type II subsequent event because the conditions causing the bankruptcy arose after the balance sheet date (December 31, Year 1). Therefore, the financial statements should not be adjusted, but the event must be disclosed in the notes if it is material.
Why the other options are wrong
- A. This would be appropriate for a Type I subsequent event, where conditions existed at the balance sheet date.
- B. The event is material and requires disclosure, even if it doesn't require adjustment.
- D. A direct write-off is an accounting method, but the key issue here is whether to adjust the prior period statements or disclose, given the timing of the event.
Type II Subsequent Event
A subsequent event that provides evidence about conditions that did not exist at the balance sheet date but arose after that date. These events require disclosure in the financial statements if material, but no adjustment to the financial statements themselves.
- Conditions arose after balance sheet date
- Requires disclosure in notes if material
- No adjustment to financial statements
Memory trick: After the balance sheet, if it's new news, just disclose; if it confirms old clues, adjust and show.