Recording Liabilities and the Effect on Bonuses
Response to the following problem:
John Flowers, president of Marquette Company, is paid a salary plus a bonus equal to 10% of pretax income. The company has just computed its pretax income to be $3.4 million. Based on this income, Flowers expects to receive a bonus of $340,000. However, the company has just been told by outside experts that it may have an environmental liability of $2.1 million and that, based on new actuarial estimates, the recorded amount of postretirement benefits is too low by $1.2 million. The experts recommend that both of these liabilities be recorded, which would reduce income to $100,000 and Flowers' bonus to $10,000. Flowers believes he does not need to record the adjustments for the following reasons: the environmental liability is not certain, the amount of the potential liability can't be accurately estimated, and "actuarial estimates" are always changing.
Is Flowers violating GAAP if he refuses to allow the company to adjust pretax income, or is the decision to not record the adjustments acceptable because of the uncertainty of the liabilities and the amounts?