What is the underlying concept that supports the immediate recognition of a contingent loss?
- Substance over form.
A contingent loss has not occurred as of the balance sheet date, but since it is probable and estimable, and would result in lower income and net assets, the loss should be recognized. A contingent gain that also is probable and estimable is not recognized. Thus, it is only the direction of the effect of the item that causes the accounting treatment to be different.
This can only be explained by conservatism: under conditions of uncertainty, report lower earnings and net assets. Uncertain gains are not allowed to be recognized because they may raise the expectations of investors unnecessarily. Uncertain gains may not be realized.
Brite Corp. had the following liabilities at December 31, 2004:
- Accounts payable $55,000
- Unsecured notes, 8%, due 7-1-05 $400,000
- Accrued expenses $35,000
- Contingent liability $450,000
- Deferred income tax liability $25,000
- Senior bonds, 7%, due 3-31-05 $1,000,000
The contingent liability is an accrual for possible losses on a $1,000,000 lawsuit filed against Brite. Brite's legal counsel expects the suit to be settled in 2006 and has estimated that Brite will be liable for damages in the range of $450,000 to $750,000.
The deferred income tax liability is not related to an asset for financial reporting and is expected to reverse in 2006.
What amount should Brite report in its December 31, 2004 balance sheet for current liabilities?
Current liabilities include:
- Accounts payable $55,000
- 8% notes $400,000
- Accrued expenses $35,000
- 7% bonds $1,000,000
- Total current liabilities $1,490,000
The four items above are all due within one year of the balance sheet date and thus are included in current liabilities.
The contingent liability, although shown in the correct amount, is not current as of 12/31/04 because it is not expected to be paid until 2006. The deferred tax liability is not related to an asset, so it must be related to another liability.
The other liability could not be a current liability because the difference is not expected to reverse until 2006. (Reversal would occur when the other liability is paid.)
Therefore, the deferred tax liability must be classified as noncurrent.
During 2004, a former employee of Dane Co. began a suit against Dane for wrongful termination in November 2003. After considering all of the facts, Dane's legal counsel believes that the former employee will prevail and will probably receive damages between $1,000,000 and $1,500,000, with $1,300,000 being the most likely amount. Dane's financial statements for the year ended December 31, 2003, will not be issued until February 2004. In its December 31, 2003, balance sheet, what amount should Dane report as a liability with respect to the suit?
- $ -0-
When an estimate of the amount of a probable loss is more likely than others in the range, that amount is used for the accrual. If all amounts in the range are equally probable, then the lowest amount in the range is used for the accrual.
Hudson Corp. operates several factories that manufacture medical equipment. The factories have a historical cost of $200 million. Near the end of the company's fiscal year, a change in business climate related to a competitor's innovative products indicated to Hudson's management that the $170 million carrying amount of the assets of one of Hudson's factories may not be recoverable. Management identified cash flows from this factory and estimated that the undiscounted future cash flows over the remaining useful life of the factory would be $150 million. The fair value of the factory's assets is reliably estimated to be $135 million. The change in business climate requires investigation of possible impairment. Which of the following amounts is the impairment loss?
- $15 million
- $20 million
- $35 million
- $65 million
Under U.S. GAAP, impairment testing is a two step process. The first step compares the assets' carry value (CV) to its undiscounted cash flows (UCF). In this problem the CV > UCF; therefore the asset is potentially impaired and we must go to the second step. The second step compares the assets CV to its fair value (FV). In this problem the FV < CV and the asset is written down to its FV. $170 million - $135 million = $35 million impairment loss.
Martin Pharmaceutical Co. is currently involved in two lawsuits. One is a class-action suit in which consumers claim that one of Martin's best selling drugs caused severe health problems. It is reasonably possible that Martin will lose the suit and have to pay $20 million in damages. Martin is suing another company for false advertising and false claims against Martin. It is probable that Martin will win the suit and be awarded $5 million in damages. What amount should Martin report on its financial statements as a result of these two lawsuits?
- $5 million income
- $15 million expense.
- $20 million expense.
A contingent liability is recognized only when occurrence is probable and estimable. This class-action suit is reasonably possible (a 50/50 chance) but not probable (a higher threshold). Therefore, a liability for the class-action suit would not be accrued. Contingent assets are not recognized until the amount is actually received, even if the outcome is probable and estimable. Therefore, no asset is accrued for the suit where Martin may be awarded damages.
Vadis Co. sells appliances that include a three-year warranty. Service calls under the warranty are performed by an independent mechanic under a contract with Vadis. Based on experience, warranty costs are estimated at $30 for each machine sold.
When should Vadis recognize these warranty costs?
- Evenly over the life of the warranty.
- When the service calls are performed.
- When payments are made to the mechanic.
- When the machines are sold.
When the machines are sold.
At the point of sale, Vadis has committed to service the products it sells. The firm has incurred a recognized obligation at that point because it is both probable and estimable (FAS 5).
The cost of the warranty, therefore, is recognized in the year of sale. The cost (expense) is the temporary account that measures the reduction in net assets from operations (earnings) caused by the increase in the obligation.
A less acceptable explanation is that the warranty cost or expense should be matched against the sales it helped to produce. Either explanation leads to the same result, however.
On April 1, 2003, Ash Corp. began offering a new product for sale under a one-year warranty. Of the 5,000 units in inventory at April 1, 2003, 3,000 had been sold by June 30, 2003. Based on its experience with similar products, Ash estimated that the average warranty cost per unit sold would be $8. Actual warranty costs incurred from April 1 through June 30, 2003, were $7,000. At June 30, 2003, what amount should Ash report as estimated warranty liability?
The ending warranty liability balance is the warranty expense recognized in that year based on sales (this amount increases the liability), less the warranty costs actually incurred. Therefore, the ending warranty liability is $17,000 [expense of ($8)3,000 - actual costs of $7,000].
Management can estimate the amount of loss that will occur if a foreign government expropriates some company assets. If expropriation is reasonably possible, a loss contingency should be:
- Disclosed but not accrued as a liability.
- Disclosed and accrued as a liability.
- Accrued as a liability but not disclosed.
- Neither accrued as a liability nor disclosed.
Disclosed but not accrued as a liability.
This contingent liability is not probable, only reasonably possible. Therefore, only footnote disclosure is mandated. Accrual requires a probable expropriation.
At December 31, 2004, Date Co. awaits judgment on a lawsuit for a competitor's infringement of Date's patent. Legal counsel believes it is probable that Date will win the suit and indicated the most likely award together with a range of possible awards.
How should the lawsuit be reported in Date's 2004 financial statements?
- In note disclosure only.
- By accrual for the most likely award.
- By accrual for the lowest amount of the range of possible awards.
- Neither in note disclosure nor by accrual.
In note disclosure only.
This is a gain contingency. Gain contingencies are footnoted at most, not accrued. To recognize gain contingencies in the accounts would violate the conservatism constraint.
Bell Co. is a defendant in a lawsuit that could result in a large payment to the plaintiff. Bell's attorney believes that there is a 90% chance that Bell will lose the suit, and estimates that the loss will be anywhere from $5,000,000 to $20,000,000 and possibly as much as $30,000,000. None of the estimates is better than the others. What amount of liability should Bell report on its balance sheet related to the lawsuit?
- $ -0-
When no amount within the range of estimated loss amounts is more probable than the others, the lowest amount in the range is recognized, provided that the loss is probable. A 90% probability is sufficient to meet the "probable and estimable" requirement of FAS 5 for recognizing contingent liabilities.
In 2003, a personal injury lawsuit was brought against Halsey Co.
Based on counsel's estimate, Halsey reported a $50,000 liability in its December 31, 2003, balance sheet. In November 2004, Halsey received a favorable judgment, requiring the plaintiff to reimburse Halsey for expenses of $30,000. The plaintiff has appealed the decision, and Halsey's counsel is unable to predict the outcome of the appeal.
In its December 31, 2004, balance sheet, Halsey should report what amounts of asset and liability related to these legal actions?
- Asset - $0
- Liability - $0
The contingent liability at the end of 2003 no longer exists.
It is not probable, given the facts in the question, that Halsey will be required to make any payment in the lawsuit. The favorable judgment indicates a contingent gain (asset). Contingent gains are not recognized in the accounts, but only footnoted.
On February 5, 2005, an employee filed a $2,000,000 lawsuit against Steel Co. for damages suffered when one of Steel's plants exploded on December 29, 2004.
Steel's legal counsel expects the company will lose the lawsuit and estimates the loss to be between $500,000 and $1,000,000. The employee has offered to settle the lawsuit out of court for $900,000, but Steel will not agree to the settlement.
In its December 31, 2004, balance sheet, what amount should Steel report as liability from lawsuit?
This is a recognized contingent liability because it is probable that a loss has occurred. When a range of losses is possible, with no one point in the range more probable than the others, the lower limit of the range is the amount recognized.
Snelling Co. did not record an accrual for a contingent loss, but disclosed the nature of the contingency and the range of the possible loss.
How likely is the loss?
- Reasonably possible.
Remote contingent losses may be disclosed in the footnotes, but there is no requirement to do so. Probable contingent losses are accrued. Certain losses are no longer contingent losses. When a loss is reasonably possible, it is footnoted. It is most likely that the loss is reasonably possible when a range of losses is disclosed.
Wall Co. sells a product under a two-year warranty. The estimated cost of warranty repairs is 2% of net sales. During Wall's first two years in business, it made the following sales and incurred the following warranty repair costs:
- Total sales $250,000
- Total repair costs incurred $4,500
- Total sales $300,000
- Total repair costs incurred $5,000
What amount should Wall report as warranty expense for year 2?
The recognized warranty expense is based on sales in the period because a regular warranty is part of the sales effort. The full cost of the warranty servicing is matched against sales in the year of the sale. With sales of $300,000 in year 2, recognized warranty expense is 2% of that amount or $6,000. At year-end, the firm is contingently liable for warranty claims service in the amount of $6,000 for that year's sales. Warranty liability is credited for $6,000. As actual repairs are made, the warranty liability is reduced. Some of the estimated $6,000 repair cost may be included in the $5,000 amount of actual repair cost incurred in year 2.
East Corp. manufactures stereo systems that carry a two-year warranty against defects. Based on past experience, warranty costs are estimated at 4% of sales for the warranty period.
During 2005, stereo system sales totaled $3,000,000, and warranty costs of $67,500 were incurred.
In its income statement for the year ended December 31, 2005, East should report warranty expense of:
Warranty expense is recognized in the year of sale under the accrual accounting system.
Warranties are a part of the selling effort, and the associated expense should be recognized when the liability is probable and estimable (in 2005). The actual repairs reduce the liability recognized when the expense was recorded (in the year of sale).
The $120,000 of warranty expense in 2005 = .04(sales in 2005) = .04($3,000,000). The relevant entries for 2005 are:
Warranty expense 120,000
- Warranty liability 120,000
Warranty liability 67,500
- Cash, parts, etc. 67,500
On November 25, 2005, an explosion occurred at a Rex Co. plant, causing extensive property damage to area buildings.
By March 10, 2006, claims had been asserted against Rex. Rex's management and counsel concluded that it is probable Rex will be responsible for damages, and that $3,500,000 would be a reasonable estimate of its liability. Rex's $10,000,000 comprehensive public liability policy has a $500,000 deductible clause.
Rex's December 31, 2005, financial statements, issued on March 25, 2006, should report this item as:
- A footnote disclosure indicating the probable loss of $3,500,000.
- An accrued liability of $3,500,000.
- An accrued liability of $500,000.
- A footnote disclosure indicating the probable loss of $500,000.
An accrued liability of $500,000.
Contingent liabilities that are probable and estimable, like this one, must be recognized in the accounts. The $500,000 deductible is the amount that will most likely have to be paid.
Case Cereal Co. frequently distributes coupons to promote new products. On October 1, 2004, Case mailed 1,000,000 coupons for $.45 off each box of cereal purchased. Case expects 120,000 of these coupons to be redeemed before the December 31, 2004, expiration date. It takes 30 days from the redemption date for Case to receive the coupons from the retailers. Case reimburses the retailers an additional $.05 for each coupon redeemed. As of December 31, 2004, Case had paid retailers $25,000 related to these coupons and had 50,000 coupons on hand that had not been processed for payment. What amount should Case report as a liability for coupons in its December 31, 2004, balance sheets?
120,000 coupons expected to be redeemed x ($.45 + $.05) $60,000
- Less amount already paid ($25,000)
- Liability at 12/31/91 $35,000
The 50,000 coupons on hand are included in the ending liability and account for $25,000 of the total liability [50,000($.45 + $.05)]. The $25,000 already paid represents another 50,000 coupons [$25,000/($.45 + $.05)].
Therefore, another 20,000 coupons have yet to be redeemed out of a total of 120,000 redemptions. These 20,000 coupons account for the remaining $10,000 of the liability [20,000($.45 + $.05)].
Dunn Trading Stamp Co. records stamp service revenue and provides for the cost of redemptions in the year stamps are sold to licensees. Dunn's past experience indicates that only 80% of the stamps sold to licensees will be redeemed. Dunn's liability for stamp redemptions was $6,000,000 at December 31, 2005. Additional information for 2006 is as follows:
- Stamp service revenue from stamps sold to licensees $4,000,000
- Cost of redemptions (stamps sold prior to 1/1/06) $2,750,000
If all the stamps sold in 2006 were presented for redemption in 2007, the redemption cost would be $2,250,000. What amount should Dunn report as a liability for stamp redemptions at December 31, 2006?
- Beginning liability balance $6,000,000
- Plus estimated redemptions for 2006: .80($2,250,000) $1,800,000
- Less actual redemptions in 2006 ($2,750,000)
- Equals ending liability balance $5,050,000
The firm estimates the redemption cost in the year of sale, much like a warranty liability. For 2006, this increases the redemption liability by $1,800,000. When actual redemptions occur, the liability is extinguished at the cost of the redemptions ($2,750,000).
Eagle Co. has cosigned the mortgage note on the home of its president, guaranteeing the indebtedness in the event that the president should default. Eagle considers the likelihood of default to be remote.
How should the guarantee be treated in Eagle's financial statements?
- Disclosed only.
- Accrued only.
- Accrued and disclosed.
- Neither accrued nor disclosed.
In the interest of conservatism and disclosure, the guarantee should be disclosed. It is not required to be accrued because the probability is remote that the firm will have to pay the note.
During 2005, Smith Co. filed suit against West, Inc. seeking damages for patent infringement.
At December 31, 2005, Smith's legal counsel believed that it was probable that Smith would be successful against West for an estimated amount in the range of $75,000 to $150,000, with all amounts in the range considered equally likely. In March 2006, Smith was awarded $100,000 and received full payment thereof.
In its 2005 financial statements, issued in February 2006, how should this award be reported?
- As a receivable and revenue of $100,000.
- As a receivable and deferred revenue of $100,000.
- As a disclosure of a contingent gain of $100,000.
- As a disclosure of a contingent gain of an undetermined amount in the range of $75,000 to $150,000.
As a disclosure of a contingent gain of an undetermined amount in the range of $75,000 to $150,000.
Contingent gains are not recognized in the accounts. At most, footnote disclosure is considered acceptable reporting. This is the best answer because no amount in the range of possible values is more likely than any other. The $100,000 amount was not known when the financial statements were published.
In 2003, a contract dispute between Dollis Co. and Brooks Co. was submitted to binding arbitration.
In 2003, each party's attorney indicated privately that the probable award in Dollis' favor could be reasonably estimated. In 2004, the arbitrator decided in favor of Dollis.
When should Dollis and Brooks recognize their respective gain and loss?
- Dollis' gain
- Brooks' loss
- Dollis' gain - 2004
- Brooks' loss - 2003
Both the gain and loss are contingent items at the end of 2003. Contingent losses are recognized when probable and estimable - 2003 in this case. Contingent gains are not recognized until realized - 2004 in this case.
During 2003, Manfred Corp. guaranteed a supplier's $500,000 loan from a bank.
On October 1, 2004, Manfred was notified that the supplier had defaulted on the loan and filed for bankruptcy protection. Counsel believes Manfred will probably have to pay between $250,000 and $450,000 under its guarantee.
As a result of the supplier's bankruptcy, Manfred entered into a contract in December 2004 to retool its machines so that Manfred could accept parts from other suppliers. Retooling costs are estimated to be $300,000.
What amount should Manfred report as a liability in its December 31, 2004, balance sheet?
The retooling costs are not part of the liability, but are rather a response to changing business conditions. They most likely would be capitalized and amortized over their useful life. The liability is a contingent liability.
The amount depends on the outcome of the bankruptcy proceedings. When a range of values is estimated with no one value being more probable than the others, the lowest amount is accrued. Thus, $250,000 is accrued as of the end of 2004.
In June 2004, Northan Retailers sold refundable merchandise coupons. Northan received $10 for each coupon redeemable from July 1 to December 31, 2004, for merchandise with a retail price of $11. At June 30, 2004, how should Northan report these coupon transactions?
- Unearned revenues at the merchandise's retail price.
- Unearned revenues at the cash received amount.
- Revenues at the merchandise's retail price.
- Revenues at the cash received amount.
Unearned revenues at the cash received amount.
The amounts received represent unearned revenue (a liability) because the merchandise has not yet been provided to the customer. The cash received is an advance on future purchases by customers. The customers have prepaid sales and have a claim on the firm for merchandise. When the customers submit the coupons for redemption, the liability is extinguished and sales are recorded.
The amount to be recorded for the liability (unearned revenue) can only be the amount collected from the customer. The sales at redemption will be recorded at the $10 amount, rather than $11. The firm is simply providing a discount price for a customer that is committing to a purchase well ahead of delivery.
Invern, Inc. has a self-insurance plan.
Each year, retained earnings is appropriated for contingencies in an amount equal to insurance premiums saved less recognized losses from lawsuits and other claims. As a result of a 2005 accident, Invern is a defendant in a lawsuit in which it will probably have to pay damages of $190,000.
What are the effects of this lawsuit's probable outcome on Invern's 2005 financial statements?
- An increase in expenses and no effect on liabilities.
- An increase in both expenses and liabilities.
- No effect on expenses and an increase in liabilities.
- No effect on either expenses or liabilities.
An increase in both expenses and liabilities.
The information about self-insurance (which means no insurance) is irrelevant to the problem except that if the firm loses the lawsuit, there will be no insurance coverage. This is a contingent liability. It is probable, and the amount is estimable.
Therefore, expenses (or a loss) and a liability are recognized for $190,000.
During year 2, a former employee of Dane Co. began a suit against Dane for wrongful termination in November year 1. After considering all of the facts, Dane’s legal counsel believes that the former employee will prevail and will probably receive damages of between $1,000,000 and $1,500,000, with $1,300,000 being the most likely amount. Dane’s financial statements for the year ended December 31, year 1, will not be issued until February year 2. In its December 31, year 1 balance sheet, what amount should Dane report as a liability with respect to the suit?
If the loss is probable and reasonably estimable, the most likely amount should be recorded as a loss on the income statement, and a corresponding liability should be reported on the balance sheet. The most likely amount of the loss is $1,300,000.