Subsequent events: adjust or disclose? (Type I vs II)

Answer D. The lawsuit existed as of December 31, Year 1, and the February 15 settlement provides additional evidence about a condition that existed at the balance-sheet date. Under U.S. GAAP subsequent-events guidance (Type I events), such post‑period settlements require adjustment to the financial statements. Because the Year 1 statements had not been issued as of February 28, Year 2, Torrance should recognize the liability and loss of $700,000 in Year 1.

Why not A: Candidates may recall the rule to accrue the minimum of a range when a loss is probable and only a range can be estimated, but that rule doesn't apply here: the settlement after year‑end establishes the actual amount, so the Year 1 statements should be adjusted to the settled $700,000.

Why not B: This is tempting because the settlement occurred after the reporting date, but the settlement confirms a condition that existed at the balance-sheet date; that makes it a Type I (adjusting) subsequent event, requiring accrual rather than only disclosure.

Why not C: This lure relies on the rule that a 'reasonably possible' contingency typically leads to disclosure only, but it ignores that the post‑period settlement provides evidence changing the analysis; the settlement requires adjustment because it relates to a condition existing at the balance-sheet date.

Answer C. Under ASC 855, subsequent events that provide additional evidence about conditions existing at the balance sheet date are adjusting events; those that arise from new conditions after the balance sheet date are nonadjusting and disclosed. The governing factor is whether the bankruptcy reflects deterioration that existed at December 31, here, the pre‑year‑end falling sales and the bank's credit reduction support that insolvency existed at year‑end and therefore justify an allowance. The post‑period partial payment and the filing are relevant facts but do not change the controlling test.

Why not A: This distracts because an event must occur before issuance to be considered as a subsequent event. However, timing relative to issuance alone does not determine adjustment versus disclosure, the key is whether the event provides evidence about conditions that existed at the balance sheet date.

Why not B: Materiality is tempting because it affects presentation and disclosure, but it does not control whether an adjusting entry is required. Recognition depends on the nature of the post‑period information and whether it evidences pre‑existing conditions.

Why not D: A post‑period payment can be persuasive evidence about collectibility and therefore tempts as a reason not to adjust. It is only one piece of evidence, however, the governing test remains whether the bankruptcy reflected conditions existing at year‑end; pre‑year‑end deterioration and the bank's credit action are stronger indicators of a pre‑existing condition.

Answer D. Under ASC 855 (Subsequent Events) and ASC 450 (Contingencies), a settlement reached after the balance sheet date but before issuance that provides additional evidence about conditions existing at the balance sheet date is an adjusting event. Westport's Feb 10 settlement clarifies the amount of a loss that existed at Dec 31, so the accrual should be adjusted to the settled amount and the settlement disclosed.

Why not A: Tempting because the settlement occurred after year-end, which often indicates a nonadjusting event; however, because the settlement provides definitive evidence about the amount of a loss that existed at the balance sheet date and occurred before issuance, ASC 855 requires adjusting the prior‑period estimate rather than only disclosing it.

Why not B: Tempting because the recorded accrual underestimated the eventual settlement, but incorrect: an error correction (ASC 250) applies to mistakes in applying GAAP, not to an estimate that is later refined by subsequent events. A post‑period settlement that clarifies an estimate is an adjusting event, so the accrual, not retained earnings, should be adjusted.

Why not C: Tempting because some would defer recognition until cash is paid, but incorrect: the settlement before issuance refines the estimate of a loss existing at Dec 31, so the additional $0.6 million should be included in Year 1 rather than recorded as a Year 2 expense.

Answer A. The bank default occurred on December 20, Year 1, so the adverse condition existed at the balance sheet date. Subsequent information (the public report and later bankruptcy filing) provides evidence about that preexisting condition and therefore requires adjustment of the Year 1 receivable/allowance before issuance. Ridgeway's lack of knowledge at year end does not avoid the need to adjust when postperiod evidence confirms a condition that existed at the balance sheet date.

Why not B: This choice is tempting because the bankruptcy filing happened after year end, and many postperiod events are nonadjusting. It is wrong because the bank default was dated December 20, Year 1, indicating the condition existed at the balance sheet date; information discovered after year end that provides evidence of such preexisting conditions requires adjustment, not merely disclosure.

Why not C: Candidates may think a material effect requires a restatement. That is misleading here: restatements correct errors in accounting or preparation. Because this is a subsequent event that provides evidence about conditions existing at the balance sheet date and the statements have not been issued, the proper action is to adjust the Year 1 amounts before issuance, not treat it as a prior-period error requiring restatement.

Why not D: This option appeals to the idea that unknown events at year end or an existing small allowance mean no action is needed. It is incorrect because later evidence that a condition existed at the balance sheet date can reveal the allowance is inadequate; management's lack of knowledge at year end does not eliminate the requirement to adjust when postperiod evidence confirms a preexisting adverse condition.

Answer B. Events after the balance sheet date are evaluated through the issuance date. Events that provide evidence of conditions that existed at the balance sheet date require adjustment; Customer X's bankruptcy, combined with the pre-year-end missed payments, provides evidence of collectibility problems that existed at December 31 and requires an allowance. The warehouse fire arose from a condition that began after year-end and is a non-adjusting event that should be disclosed in the notes rather than recognized in Year 1 amounts.

Why not A: This is tempting because both events occurred before issuance, but only events that provide evidence of conditions existing at the balance sheet date are adjusting. The fire resulted from a condition that arose after year-end, so it should be disclosed, not recognized.

Why not C: This choice ignores that some subsequent events provide additional evidence about conditions that existed at the balance sheet date. Customer X's bankruptcy, together with pre-year-end missed payments, evidences a preexisting collectibility problem and therefore requires adjustment (an allowance) to Year 1 amounts.

Why not D: This reverses the correct rule. The fire arose after the balance sheet date and does not evidence a condition that existed at year-end, so it is non-adjusting; the bankruptcy provides evidence of preexisting collectibility issues and requires an adjustment.