about CONTINGENCIES
Uncertainty existence of an obligation (or impairment of an asset--A/R, BD expense & Allowance for uncollectible accounts) that will be resolved only when some future event happens (e.g., pending lawsuits and product warranties). Accounting for Loss Contingencies depends on: (1) how likely there is to be a loss; and if a loss, (2) whether the amount is know or can be estimated. There are three possible accounting treatments: (1) "book it"--accrue the loss and disclose details, (2) disclose in footnote only, and (3) do not disclose--ignore it. Likelihood Dollar Amount of Potential Loss Known or Not Reasonably Reasonably Estimable Estimable Book it & disclose Disclose only NO disclosure required Disclose only Disclose only NO disclosure required
Probable Reasonably possible Remote
If "disclose", then (1) nature of contingency and (2) est. of probable loss or range of loss, or statement that estimated loss cannot be made. If some amount in range appears more likely than any other, then accrue the amount. If no amount seems more likely, then accrue the low end and disclose the high end.
Accounting 302
L. DuCharme
Chapter 13--Contingencies
page 1
Product Warranties--typically accrued. Match warranty expense with product sales. Estimate expense. Current or split between current and L-T liability depending on when costs are expected to be incurred. Cash basis required for taxes and when amount of liability cannot be reasonably determined. Warranty Expense Cash, inv., W/P, A/P, etc.
(when warranty work is performed)
$347 $347
-----------------------------------------------------------------------------Assume you sell a durable product with a 3-year warranty. From past experience, you estimate a 1% of sales warranty cost in the first year, 2% in the second year, and 3% in the third year following sale. In 2001, you made $1,000,000 sales of the product.
EOP adj. Entry (2001) (Accrual Basis): Warranty Expense $60,000 Warranty Liability: current $10,000 Warranty Liability: L-T 50,000 When warranty work is performed: Warranty Liability: current Cash, Inv., W/P, A/P, etc.
(when warranty work is performed)
(6% * $1 M)
$347 $347
Accounting 302
L. DuCharme
Chapter 13--Contingencies
page 2
Extended Warranty--(sold separate from product) earn revenue over the life of the warranty--Sales warranty basis. Use straight-line basis or if materially different, by the same pattern proportional to the costs. Cash $5,050 Sales Unearned Warranty Revenue
(At time of sale: product and extended 2-year warranty)
$5,000 50
Warranty Expense Cash, inv., W/P, A/P, etc.
(when extended-warranty work is performed)
$27 $27
Unearned Warranty Revenue Warranty Revenue
(End of 1 year of extended warranty))
st
$25 $25
Accounting 302
L. DuCharme
Chapter 13--Contingencies
page 3
Cents-off coupons--defer expense until coupons are redeemed. In period that coupons are issued, estimate future redemptions. Match future redemptions with future sales. In practice, firms either (1) recognize all expense in period coupons are issued (like premiums), or (2) recognize all expense when reimbursements are made (cash-basis accounting), no liability is recognized. "Best way" (matches revenues and expenses best) Deferred promotional expense $220,000 Estimated coupon liability
(when coupons are issued)
$220,000
Estimated coupon liability Cash
$50,000 $50,000 $50,000
Promotional expense $50,000 Deferred promotional expense
(when coupons are reimbursed)
(1) Promotional expense Estimated promotional liability
(when coupons are issued)
Estimated promotional liability Cash
(when coupons are reimbursed)
(2) Promotional expense Cash
(record only when coupons are redeemed)
yyy yyy
*** It is an issue of matching, materiality, and cost-benefit.***
Accounting 302 L. DuCharme Chapter 13--Contingencies page 4
Premiums--cash rebates, toasters (banks), Shuck's oil rebates, etc. In period the product/service is sold, companies need to recognize the estimated amount of cash or cost of noncash premiums to be given out. Promotional expense xxx Estimated promotional liability
(at time of sale)
xxx
Lawsuit Contingencies--common, typically nonspecific disclosure. Accrual of a loss contingency for unsettled litigation is almost never done (even if probable and estimable). Subsequent Events: Any material events that occur after the fiscal year end but before financial statements are issued must be disclosed (not accrued) in a "subsequent events" footnote (e.g., lawsuit filed or settled, issue of debt or stock, business combinations, discontinued operations). Gain Contingencies Never accrued (very rare accrual) Recognized only when they are realized Should be disclosed in footnote (if material) Have to avoid giving "misleading implications as to the likelihood of realization." (SFAS #5) Self insurance: no accrual of estimated losses due to future events. However, need to accrue estimated & probable losses from past uninsured 302 injuries.
Accounting L. DuCharme Chapter 13--Contingencies page 5
Asset Retirement Obligations (AROs)
As part of the operating agreement with the State of Utah, you are required to landscape a big pile of dirt, make a lake, and provide picnic facilities for a public park. This is all being done to reclaim land that you will be using for your mining operations. You are paying the current owner $2 million for the land and it will take another $3 million to develop the mine and get it ready for its intended use. You estimate that the cost to reclaim the land will be $1 million in 10 years when you are done with the mine. You use a 8% discount rate. 1) book the PV of the reclaim cost in its related asset acctg: Mine $463,190 Mine Reclaim Obligation $463,190
(include PV of cost to reclaim in mine acctg.; 0.46319*1m)
2) expense the reclaim cost over the life of the asset Depreciation Exp. $46,319 A/D $46,319 3) recognize increase in value of the obligation each period: 8% * balance in reclaim obligation acct. Interest Expense $37,055 Mine Reclaim Obligation $37,055 4) When you reclaim: Mine Reclaim Obligation $1,000,000 Cash (various accts.) $1,230,000 Loss on settlement of ARO 230,000
Accounting 302
L. DuCharme
Chapter 13--Contingencies
page 6
SUBSEQUENT EVENTS
If information becomes available that sheds light on a contingency that existed when the fiscal year ended, that information should be used in determining the probability of a loss contingency materializing and in estimating the amount of the loss.
Cause of Loss Contingency Clarification ______________________________________________________________ Fiscal Year Ends Statements Financial
If an event giving rise to a contingency occurs after the yearend, a liability should not be accrued.
Cause of Loss Contingency Clarification or Clarification ______________________________________________________________ Fiscal Year Ends Financial Statements
Accounting 302
L. DuCharme
Chapter 13--Contingencies
page 7
UNASSERTED CLAIMS AND ASSESSMENTS
It must be probable that an unasserted claim or assessment or an unfiled lawsuit will occur before considering whether and how to report the possible loss.
Example: The IRS is in the process of auditing a company's tax returns, but has not proposed a deficiency assessment. Since the claim or assessment is unasserted as yet, a two step process is involved in deciding how it should be reported: 1. Is a claim or assessment probable? {If not, no disclosure is needed.} 2. Only if a claim or assessment is probable should we evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated.
If the conclusion of step 1 is that the claim or assessment is not probable, no further action is required.
Accounting 302
L. DuCharme
Chapter 13--Contingencies
page 8
DECISIONMAKERS' PERSPECTIVE
Current liabilities impact a company's liquidity. Liquid...