7. In summer 2005, TimeWarner Inc. announced they were setting aside $3 billion to settle lawsuits from shareholders who alleged that they were wrongfully misled by executives at TimeWarner and AOL

7. In summer 2005, TimeWarner Inc. announced they were “setting aside” $3 billion to settle lawsuits from shareholders who alleged that they were wrongfully misled by executives at TimeWarner and AOL at the time of the AOL/Time Warner “merger”. This all dates back to the height of the dot-com “bubble” in early 2000 when the combined market valuation of both companies (outstanding common stock times market price of the stock) exceeded more than $300 billion; now, the Company’s market valuation is much less.

The lawsuits were actually brought against TimeWarner in 2003 and early 2004 at which time the Company had said the lawsuits were “without merit”, and they were “vigorously” defending the lawsuits.

Assume that “setting aside” meant that the Company set-up a liability for the eventual settlement of the lawsuits with a corresponding charge that was run through the 2005 income statement. Also assume that when this amount is actually paid-out it will then be deductible for tax purposes. Please answer the following questions. (Twelve Pts)

a) What kind of an accounting change is this? It seems that TimeWarner suddenly changed its position with regard to these lawsuits. Is this a change in accounting principle? An error? An estimate? Explain your answer.

b) How did this affect the 2005 cash flow statement? Be specific and provide amounts. {Assume TimeWarner uses the indirect method and also assume a 40% tax rate.}

c) How did this affect future cash flow statements when the lawsuits were actually settled, i.e., money was paid to the plaintiffs?

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