Cookie Jar Reserves: The Case of Callaway Golf Company.(Instructor's Note) (2007)

CASE DESCRIPTION This case requires the student to evaluate how estimates and more importantly changes in estimates affect a company's financial statements. Students are required to research Generally Accepted Accounting Principles (GAAP) regarding, changes in estimates and the correction of errors. The case is appropriate for junior level intermediate financial accounting courses or senior level auditing courses. While the accounting issue is easy to understand, there is room for interpretation of the accounting standards that make the case interesting. The difficulty level of the case is medium. The suggested final product of this case is a short memo where the student evaluates possible treatments for the accounting change and makes a recommendation of how the accounting change should be treated by the company in their annual financial statements. The student is also asked to evaluate the impact of the recommended solution on the company's financial statements. It is also possible to use the case as a vehicle for discussion when presented by the professor in a class setting. The case is adapted from Callaway Golf Company's 8-K filing where a disagreement between Callaway Golf Company and their auditor is discussed. Additional information is taken from Callaway Golf Company's 10-K filing. As such, this case exposes students to a real-world situation where accountants and auditors are required to make an important judgment call. CASE SYNOPSIS How could a publicly held company that is in the public's eye and whose stock is traded on the NYSE have four different auditors in approximately one year? This case details the strange set of events that led Callaway Golf Company (Callaway) to have four different auditors in a short period of time. The culminating event of the case is a disagreement between Callaway and the auditing firm of KPMG Peat Marwick (KPMG) regarding the appropriate accounting treatment for a financial statement item. While most companies and auditors go to great efforts to keep any accounting dispute private, both Callaway and the auditor in this case were willing to make the details of the dispute public. As such, this case provides some interesting details on the relationship between a company and its auditor and how accounting standards are often open to different interpretations. Callaway is known for making numerous types of golf equipment, including clubs, putters, balls, and drivers. In March of 2002, Arthur Andersen was dismissed by the Board of Directors of Callaway because the audit committee was concerned about the future of the accounting firm. Callaway hired KPMG to replace Arthur Andersen. In December 2002, Callaway Golf dismissed KPMG due to disagreements with management about accounting for Callaway's warranty reserves. Callaway thought that the change in the warranty reserve should be treated as a change in estimate, while KPMG thought that the change should be treated as a correction of an error. Callaway felt so strongly about this accounting issue, that when Callaway and KPMG could not agree on the appropriate accounting treatment, Callaway dismissed KPMG and hired a replacement auditor. INSTRUCTORS' NOTES The accounting issue raised in this case is the proper accounting treatment for the change in the estimated warranty liability by Callaway. There are three possible alternatives to consider: 1) a change in estimate, 2) a change in principle inseparable from a change in estimate and 3) the correction of an error. Note: In 2002 when the dispute arose, the governing accounting standard was Accounting Principles Board No. 20 (APB No. 20) Accounting Changes. In May 2005, Statement of Financial Accounting Standards No. 154 (FAS No. 154), Accounting Changes and Error Corrections, was issued and became effective December 15, 2005. The following teaching notes use FAS No. 154 for guidance since it is the current standard. It is important to note that as FAS No. …