In summer 2005, XYZ Inc. announced they were “setting aside” $3 billion to settle lawsuits from shareholders who supposed that they were wrongfully misinformed by executives at XYZ and AOL at the time of the AOL/ XYZ “merger”. This all dates back to height of the dot-com “bubble” in early 2000 when combined market valuation of both companies (outstanding common stock times market price of stock) exceeded more that $300 billion, now, Company’s market valuation is much less. Lawsuits were in fact brought against XYZ in 2003 and 2004 at which time the Company had said they were “strongly” defending these lawsuits.
Suppose that “Setting aside” mean that Company set-up the liability for eventual settlement of the lawsuits with corresponding charges which was run through the 2005 income statement. Also suppose that when this amount is really paid-out it will be deductible for tax purpose. Answer the following problems:
problem 1) What type of the accounting change is this? It appears that XYZ suddenly changed its position with regard to these lawsuits. This change is in an accounting principle? An error? An estimate?
problem 2) How must this have impacted the 2005 cash flow statement? (Suppose XYZ used indirect method and also suppose a 40% tax rate)
problem 3) How will this impact future cash flow statements when lawsuits are really settled, i.e., money paid – out to plaintiffs?