An auditor is performing an audit of financial statements and discovers that a major customer declared bankruptcy two weeks after the balance sheet date. The customer owed the client a significant amount that was deemed uncollectible. The client's financial statements were issued two months after the bankruptcy filing. How should this event be treated in the financial statements?
- AAs a Type I (adjusting) subsequent event requiring adjustment to the financial statements.
- BAs a Type II (non-adjusting) subsequent event requiring disclosure only.
- CThe event should be ignored as it occurred after the balance sheet date.
- DThe client should restate prior period financial statements to reflect the bankruptcy.
Show answer & explanationAnswer & explanation
Correct answer: A. As a Type I (adjusting) subsequent event requiring adjustment to the financial statements.
A customer's bankruptcy shortly after year-end, when the associated receivable existed at year-end, provides additional evidence about conditions that existed at the balance sheet date (i.e., the collectibility of the receivable). Therefore, it is a Type I (adjusting) subsequent event, requiring an adjustment to the allowance for doubtful accounts in the financial statements.
Why the other options are wrong
- B. This event provides evidence about a condition existing at year-end (collectibility), making it an adjusting event, not just a disclosure event.
- C. Subsequent events occurring between the balance sheet date and the issuance of financial statements must be evaluated for their impact.
- D. This event relates to the current period's financial statements, not prior periods, so restatement of prior periods is inappropriate.
Type I Subsequent Event (Adjusting)
Events occurring after the balance sheet date but before the financial statements are issued that provide additional evidence about conditions that existed at the balance sheet date, requiring adjustment to the financial statements.
- Relate to conditions existing at year-end.
- Require adjustment to financial statement amounts.
- Examples: uncollectible receivables, settlement of litigation.
Memory trick: Balance sheet date condition? Adjust the numbers, it's a Type 1 decision.