Flashcards in FAR 52 - Contingencies, Commitments, and Guarantees (Provisions) Deck (33):
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. A footnote disclosure indicating the probable loss of $3,500,000.
B. An accrued liability of $3,500,000.
C. An accrued liability of $500,000.
D. A footnote disclosure indicating the probable loss of $500,000.
C. 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.
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.
In May 2000, Caso Co. filed suit against Wayne, Inc. seeking $1,900,000 in damages for patent infringement.
A court verdict in November 2003 awarded Caso $1,500,000 in damages, but Wayne's appeal is not expected to be decided before 2005. Caso's counsel believes it is probable that Caso will be successful against Wayne for an estimated amount in the range between $800,000 and $1,100,000, with $1,000,000 considered the most likely amount.
What amount should Caso record as income from the lawsuit in the year ended December 31, 2003?
This is a gain contingency. These items are not recognized in the financial statements until the contingency is removed. Thus, no income is recognized in 2003.
What is the underlying concept that supports the immediate recognition of a contingent loss?
A. Substance over form.
D. 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.
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:
Dr. Warranty expense 120,000
Cr. Warranty liability 120,000
Dr. Warranty liability 67,500
Cr. Cash, parts, etc. 67,500
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?
B. Reasonably possible.
B. 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.
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?
A contingent liability is recognized only when occurrence is probably 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.
During 2004, Gum Co. introduced a new product carrying a two-year warranty against defects. The estimated warranty costs related to dollar sales are 2% within 12 months following the sale and 4% in the second 12 months following the sale.
Sales and actual warranty expenditures for the years ended December 31, 2004 and 2005 are as follows:
2004: Sales = $150,000; Actual warranty expenditures = $2,250
2005: Sales = $250,000; Actual warranty expenditures = $7,500
What amount should Gum report as estimated warranty liability in its December 31, 2005, balance sheet?
At Dec. 31, 2005, the total warranty liability accrued for the two years is 6% of sales (2% + 4%). This total is $24,000 (.06 x $400,000). Subtracting $9,750 of actual warranty expenditures to the end of 2005 yields the $14,250 ending warranty liability.
Management can estimate the amount of the loss that will occur if a foreign government expropriates some company assets.
If expropriation is reasonably possible, a loss contingency should be:
A. Neither accrued as a liability nor disclosed.
B. Accrued as a liability but not disclosed.
C. Disclosed and accrued as a liability.
D. Disclosed but not accrued as a liability.
D. A reasonably possible loss contingency is disclosed in the footnotes, but not recognized as a liability.
Only when the contingent loss is both probable and estimable is the loss accrued (recognized).
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].
T/F: A firm is a defendant in a suit. The legal staff estimates that the firm will be required to pay $300,000 in all probability. The firm should record the loss and liability.
T/F: A probable contingent liability cannot be estimated. Therefore, it warrants only footnote disclosure.
Also true if it can be estimated, but not probable.
T/F: A recognized contingent liability is not an actual liability because it depends on a future event.
It is an actual liability that is probable and can be reasonably estimated at the BS date.
T/F: All recognized contingent liabilities result in a future liability being recorded.
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?
A. Unearned revenues at the merchandise's retail price.
B. Unearned revenues at the cash received amount.
C. Revenues at the merchandise's retail price.
D. Revenues at the cash received amount.
B. 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.
Baker Co. sells consumer products that are packaged in boxes. Baker offered an unbreakable glass in exchange for two box tops and $1 as a promotion during the current year. The cost of the glass was $2.00. Baker estimated at the end of the year that it would be probable that 50% of the box tops will be redeemed. Baker sold 100,000 boxes of the product during the current year, and 40,000 box tops were redeemed during the year for the glasses. What amount should Baker accrue as an estimated liability at the end of the current year, related to the redemption of box tops?
This is a contingency that meets the criteria for a liability. The total estimated number of box tops redeemed is 100,000 x 50% = 50,000.
Of these 50,000, 40,000 have been redeemed, leaving 10,000 box tops estimated to be redeemed. It takes two box tops per glass, or 10,000/2 = 5,000 glasses.
At a cost of $1 per glass, the total cost is 5,000 X $1 = 5,000 as a liability.
Grim Corporation operates a plant in a foreign country. It is probable that the plant will be expropriated. However, the foreign government has indicated that Grim will receive a definite amount of compensation for the plant.
The amount of compensation is less than the fair market value but exceeds the carrying amount of the plant.
The contingency should be reported:
A. As a valuation allowance as a part of stockholders' equity.
B. As a fixed asset valuation allowance account.
C. In the notes to the financial statements.
D. In the income statement.
C. This is a gain contingency. The possible gain is the difference between the compensation amount and the carrying value of the plant. However, the gain is contingent on receipt of the compensation. Gain contingencies are reported only in the notes and are not recognized in the financial statements.
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?
A. Disclosed only.
B. Accrued only.
C. Accrued and disclosed.
D. Neither accrued nor disclosed.
A. 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.
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?
A. An increase in expenses and no effect on liabilities.
B. An increase in both expenses and liabilities.
C. No effect on expenses and an increase in liabilities.
D. No effect on either expenses or liabilities.
B. 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.
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)
Less amount already paid
Liability at 12/31/91
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)].
T/F: A contingent liability for a claim not asserted as of the balance sheet date is nonetheless recognized at the balance sheet date by a firm if it is probable that a claim will occur and have a negative outcome for the firm and the amount is estimable.
T/F: The expense for the cost of premiums that are expected to be redeemed by customers is recognized in the period of redemption.
It is recognized in the period related to the sales of the redemptions.
T/F: To be conservative, manufacturers using premiums to sell products should recognize a contingent liability based on a 100% rate of customer redemption.
Estimates are based on historical trends, or other related info from the entity or market.
T/F: Firms which are defendants in lawsuits do not recognize a contingent liability for a probable and estimable loss from the suit in order to avoid the appearance of an admission of guilt.
A contingent liability that is probable and estimable must be recognized in the FS.
Which of the following is not a contingent liability under international accounting standards?
A. A provision with a 60% chance of requiring an outflow of benefits, amount is estimable.
B. A provision with a 40% chance of requiring an outflow of benefits, amount is estimable.
C. A provision with a 90% chance of requiring an outflow of benefits, amount not estimable.
D. A possible obligation.
A. A probable (
A firm considers its regular warranty liability to be an existing liability of uncertain amount. At year-end, the firm estimates that the amount required to extinguish its warranty liability in the future is in the range of $20 to $60 million, with no amount more likely than any other. Under the US GAAP and IFRS standards, what amount will be recognized?
US GAAP = $20 million
IFRS = $40 million
International accounting standards recognize the midpoint, whereas U.S. standards recognize the low point.
Choose the correct statement regarding international accounting standards and U.S. standards as they relate to contingent liabilities and similar items.
A. All provisions under international accounting standards are contingent liabilities under U.S. standards.
B. Both sets of standards require discounting of estimated liabilities.
C. A possible obligation that requires a future event for confirmation is treated as a contingent liability under both sets of standards.
D. Both sets of standards are essentially the same with regard to recognition of contingent assets.
C. This is the one situation where both sets of standards agree with respect to classifying contingent liabilities. For international accounting standards, there are other situations calling for the reporting of a contingent liability.
Which of the following is a recognized liability for both international accounting standards and U.S. standards?
A. Regular warranty liability, 60% probability of occurring.
B. Obligation to provide rebates to customers, 90% probability of occurring.
C. Possible loss due to lawsuit, 60% probability of occurring.
D. Possible loss due to lawsuit, 40% probability of occurring.
B. For international accounting standards, this is a recognized provision. For U.S. standards, it is a recognized contingent liability.
Choose the correct statement about international accounting standards as they relate to contingent liabilities and similar items.
A. A provision that has a reasonably possible chance of requiring the outflow of benefits is treated as a contingent liability.
B. Provisions are recognized only when there is greater than a 90% probability of an outflow of benefits occurring.
C. A recognized provision is a contingent liability.
D. A provision for which it is probable that an outflow of benefits will be required is recognized, even if it is not of estimable amount.
A. A provision is a present obligation. This is one of the ways a liability can be treated as a contingent liability under international standards. If the provision involved a probable outflow, then it would be recognized, but would not be a contingent liability.
T/F: International accounting standards are more restrictive with respect to reporting contingent liabilities, compared with U.S. standards.
T/F: Under international accounting standards, "provision" refers to a recognized liability.
T/F: The term "contingent liabilities" refers to recognized under U.S. standards, but not under international accounting standards.
The term "contingent liability" under U.S. GAAP refers to both recognized and unrecognized uncertain obligations. Under IFRS a recognized contingent obligation is referred to as a "provision" and an unrecognized contingent obligation is referred to as a "contingent liability."