A public company is preparing its annual financial statements. Which of the following events occurring after the balance sheet date but before the financial statements are issued would generally require an adjustment to the financial statements under U.S. GAAP?
- AThe settlement of a lawsuit for an amount different from the liability recorded at year-end, when the cause of action existed at the balance sheet date.
- BA significant decline in the fair value of marketable securities classified as available-for-sale.
- CThe issuance of a large amount of common stock to finance future expansion.
- DA major fire destroys a significant portion of the company's uninsured manufacturing plant.
Show answer & explanationAnswer & explanation
Correct answer: A. The settlement of a lawsuit for an amount different from the liability recorded at year-end, when the cause of action existed at the balance sheet date.
Events occurring after the balance sheet date but before the financial statements are issued are classified as either Type I (recognized) or Type II (nonrecognized) subsequent events. Type I subsequent events provide additional evidence about conditions that existed at the balance sheet date and require adjustment to the financial statements. The settlement of a lawsuit for a different amount, where the cause of action existed at year-end, is a Type I event because it provides new information about a pre-existing condition (the lawsuit liability).
Why the other options are wrong
- B. A decline in fair value of AFS securities generally reflects conditions after the balance sheet date (Type II event) and requires disclosure, not adjustment, unless it indicates an other-than-temporary impairment that existed at year-end.
- C. Issuance of common stock after year-end is a new condition (Type II event) and requires disclosure, not adjustment.
- D. A fire occurring after the balance sheet date is a new condition (Type II event) and generally requires disclosure, not adjustment.
Type I Subsequent Events
Subsequent events that provide additional evidence about conditions that existed at the balance sheet date; these events require adjustment of the financial statements.
- Conditions existed at year-end.
- Provides new information about year-end estimates.
- Examples: lawsuit settlements, uncollectible receivables, inventory realization.
Memory trick: Balance date's secrets, if revealed later, demand adjustment, not just a narrator.