Section 3C - Contingencies and Commits

Question 1

• During Year 2, a former employee of Dane Co. began a suit against Dane for wrongful termination in November of 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 2, will not be issued until February of Year 3. In its December 31, Year 2, balance sheet, what amount should Dane report as a liability with respect to the suit?

$1,500,000

$1,000,000

$0

$1,300,000

Answer 1

$1,300,000

A loss contingency must be accrued if it is probable that the loss will occur and the amount can be reasonably estimated.

If a range of loss can be estimated, the best estimate within the range is accrued. Since legal counsel believes that $1,300,000 is the most likely amount to be collected, Dane should report this amount as a liability.

Question 2

A loss contingency must be accrued if it is ___that the loss will occur and the amount can be ___.

Contingent losses are ___when probable or reasonably probable.

Contingent ___are not accrued but should be ___when probable or ___probable.

Answer 2

probable , reasonably estimated

disclosed

gains , disclosed , reasonably

Question 3

Potter Co. has the following contingencies, all resulting from lawsuits in progress during the current year:

1. Probable loss contingency $1,500,000
2. Reasonably possible loss contingency 500,000
3. Probable gain contingency 700,000
4. Reasonably possible gain contingency 300,000

Potter’s accountant believes the financial statements will be misleading if the probable loss contingency is not disclosed. How much should be disclosed, and how much should be accrued in Potter’s financial statements for the current year?

1. Disclosed: $1,000,000 gain; Accrued: $1,500,000 loss and $500,000 loss
2. Disclosed: $2,000,000 loss and $1,000,000 gain; Accrued: $1,500,000 loss
3. Disclosed: $500,000 loss and $1,000,000 gain; Accrued: $1,500,000 loss and $700,000 gain
4. Disclosed: $500,000 loss and $300,000 gain; Accrued: $1,500,000 loss

Answer 3

Disclosed: $2,000,000 loss and $1,000,000 gain; Accrued: $1,500,000 loss

Contingent losses are accrued when probable and reasonably estimable. Contingent losses are disclosed when probable or reasonably probable. Contingent gains are not accrued but should be disclosed when probable or reasonably probable.

Only the reasonably probable loss should be accrued ($1,500,000). All of the gains and losses should be disclosed (Losses: $1,500,000 + $500,000 = $2,000,000, Gains: $700,000 + $300,000 = $1,000,000).

Question 4

+____ are usually not reflected in the accounts, since to do so would be to recognize revenue prior to its realization. Adequate disclosure is made of gain contingencies but care must be taken to avoid misleading implications.

Answer 4

Gain contingencies

Question 5

Probability of Occurrence___Accrual Requiremnet____Disclosure requirement

Probable___??___??

Reasonable Probable___??___??

Remote___??___??

Answer 5

Accrual Requirement___Disclosure Requirement

Probable: Accrue if reasonably estimated (if not, then just disclose)__disclose the nature & amount

Reasonable PRobable: No accrual __ nature and estimate of loss (or statement that no estimate is probable)

Remote: No accrual __ (right ot proceed against an outside party?)

Question 6

In 20X1, a personal injury lawsuit was brought against Halsey Co. Based on counsel’s estimate, Halsey reported a $50,000 liability in its December 31, 20X1, balance sheet. In November 20X2, 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, 20X2, balance sheet, Halsey should report what amounts of asset and liability related to these legal actions?

Asset: $0; Liability: $20,000

Asset: $30,000; Liability: $0

Asset: $30,000; Liability: $50,000

Asset: $0; Liability: $0

Answer 6

Asset: $0; Liability: $0

FASB ASC 450-20-25-2 provides for:

1. accrual of a loss if such loss is probable and can be reasonably estimated, and
2. no accrual of gains.

Since the outcome of the appeal cannot be predicted, no asset (gain) should be reported. Since Halsey received a favorable judgment, the liability accrued in 20X1 is no longer appropriate. (And the legal costs have probably already been expensed.) However, the lawsuit and appeal should be disclosed in a footnote.

Question 7

Which of the following methods should a company use to account for a contingent liability when the loss is probable but not reasonably estimated?

The liability should be reported as a short-term liability.

The liability should be reported as a long-term liability.

The liability should only be disclosed in the notes to the financial statements.

The liability should not be reported.

Answer 7

The liability should only be disclosed in the notes to the financial statements.

• Proper accounting for loss contingencies requires an assessment of the probability that a future event or events will confirm a loss or asset impairment or the incurrence of a liability as of the date of the financial statements. If the future event is likely to occur, it is considered probable
• . Losses that are probable should be accrued only if the loss is reasonably estimable.
• If the loss cannot be reasonably estimated, the nature of the contingency should be disclosed in the notes to the financial statements.

Question 8

Daniel Company is embroiled in a lawsuit with an individual investor. If the probability of loss from the lawsuit is remote, a loss contingency should be:

disclosed and accrued as a liability.

neither accrued as a liability nor disclosed.

accrued as a liability but not disclosed.

disclosed but not accrued as a liability.

Answer 8

neither accrued as a liability nor disclosed.

FASB ASC 450-20-25-2 requires that when the probability of a loss is remote, the loss contingency is neither accrued nor disclosed. When a loss is probable and the amount of such loss can be reasonably estimated, the loss contingency should be accrued. When a loss is reasonably possible, a loss contingency should be disclosed but not accrued.

Question 9

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 are better than the others. What amount of liability should Bell report on its balance sheet related to the lawsuit?

$0

$30,000,000

$20,000,000

$5,000,000

Answer 9

$5,000,000

If it is probable that a liability has been incurred, but no point in the range of estimated loss is more probable than any other, a company must record a loss and liability for the lowest point of the range. The company must also disclose the range of possible loss in accordance with FASB ASC 450-20-30-1.

Question 10

The absence of insurance does not mean that an asset has been impaired or a liability incurred T/F – would this require a disclosure? NOPE!

Accruals for general risk contingencies do not meet the conditions for accrual and should/should not be made.

Answer 10

true

should not

Question 11

A prerequisite for accrual of a loss contingency is that the amount can be reasonably __

This does not require, however, that a single amount can be estimated. If a range of loss can be estimated, the best estimate within the range is accrued. t/f

If no amount within the range is a better estimate than any other amount, the minimum amount in the __is accrued and the estimated range of potential loss disclosed.

Answer 11

estimated.

true

range

Question 12

During 20X1, Smith Co. filed suit against West, Inc., seeking damages for patent infringement. On December 31, 20X1, 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 20X2, Smith was awarded $100,000 and received full payment thereof. In its 20X1 financial statements, issued in February 20X2, how should this award be reported?

As a disclosure of a contingent gain of an undetermined amount in the range of $75,000 to $150,000

As a receivable and deferred revenue of $100,000

As a disclosure of a contingent gain of $100,000

As a receivable and revenue of $100,000

Answer 12

As a disclosure of a contingent gain of an undetermined amount in the range of $75,000 to $150,000

FASB ASC 450-30 reads:

• “A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.” (FASB ASC 450-30-25-1)
• “Adequate disclosure shall be made of contingencies that might result in gains, but care shall be exercised to avoid misleading implications as to the likelihood of realization.” (FASB ASC 450-30-50

Smith Co.’s financial statements should include a disclosure of a contingent gain with a range of $75,000 to $150,000.

Question 13

Ace Co. settled litigation on February 1, 20X2, for an event that occurred during 20X1. An estimated liability was determined as of December 31, 20X1. This estimate was significantly less than the final settlement. The transaction is considered to be material. The financial statements for year-end 20X1 have not been issued. How should the settlement be reported in Ace’s year-end 20X1 financial statements?

Disclosure only of the settlement

Neither a disclosure nor an accrual

Only an accrual of the settlement

Both a disclosure and an accrual

Answer 13

Both a disclosure and an accrual

Post-balance sheet events (subsequent events) should be explained in the notes to the financial statements when the event is significant. FASB ASC 855-10-55-1 contains guidance about the recognition of subsequent events: “An entity must recognize in the financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.”

Question 14

A ___is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain ___) or loss (loss ___) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.

Financial statements are considered issued when they are widely distributed to shareholders and other financial statement users for general use and reliance in a form and format that complies with GAAP. t/f

A public entity includes private companies controlled by a public company . t/f

A private company can file with the SEC

Answer 14

contingency

true

true

false -only public

Question 15

In October 20X2, Hake paid $375,000 to a former employee to settle a lawsuit out of court. The lawsuit had been filed in 20X1, and on December 31, 20X1, Hake had recorded a liability from lawsuit based on legal counsel’s estimate that the loss from the lawsuit would be between $250,000 and $750,000. Compute the amount of gain or loss from settlement of the lawsuit in 20X2.

Hake would not record a gain or loss upon settlement of the lawsuit since a contingent loss had already been recorded.

Hake would record a $375,000 gain.

Hake would record a $125,000 gain.

Hake would record a $125,000 loss.

Answer 15

Hake would record a $125,000 loss.

Hake would record a loss on the settlement of the lawsuit of $125,000, calculated as follows:

20X2 Payment - 20X1 Contingent Liability = 20X2 Loss
$375,000 - $250,000 = $125,000

On December 31, 20X1, Hake would have recorded a contingent liability of $250,000 (the minimum estimate of loss, since no amount within the range of estimates was identified as being a better estimate that any other) in accordance with FASB ASC 450-20-30-1.

Question 16

Blythe Corp. is a defendant in a lawsuit. Blythe’s attorneys believe it is reasonably possible that the suit will require Blythe to pay a substantial amount. What is the proper financial statement treatment for this contingency?

No disclosure or accrual

Accrued but not disclosed

Disclosed but not accrued

Accrued and disclosed

Answer 16

Disclosed but not accrued

If the possibility that a company will be required to pay a contingent liability is reasonably possible, the liability is not required to accrue the liability. However, the nature of the liability and an estimate of the loss (or range of loss) must be disclosed.

Question 17

A corporation entered into a purchase commitment to buy inventory. At the end of the accounting period, the current market value of the inventory was less than the fixed purchase price, by a material amount. Which of the following accounting treatments is most appropriate?

1. Neither describe the purchase obligation nor recognize a loss on the income statement or balance shee
2. Describe the nature of the contract in a note to the financial statements, recognize a loss in the income statement, and recognize a reduction in inventory equal to the amount of the loss by use of a valuation account
3. Describe the nature of the contract and the estimated amount of the loss in a note to the financial statements, but do not recognize a loss in the income statement
4. Describe the nature of the contract in a note to the financial statements, recognize a loss in the income statement, and recognize a liability for the accrued loss

Answer 17

describe the nature of the contract in a note to the financial statements, recognize a loss in the income statement, and recognize a liability for the accrued loss

Expenses are generally recognized when an enterprise’s economic benefits are consumed in revenue-earning activities or otherwise. Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have been incurred or increased, without associated economic benefits.

In this case, a loss is recognized because it has become evident that previously recognized future economic benefits of assets have been reduced without any associated economic benefits.

Question 18

If unconditional purchase obligations have not been recognized (recorded) as a liability on the balance sheet, the purchaser must disclose:

1. ___and term of the obligation
2. The ___of the fixed and determinable portion of the obligation(s)
3. The nature of any variable __of the obligation(s)
4. The amounts ___under the obligation(s) for each period for which an income statement is presented

Disclosure of the present value of these unrecorded unconditional purchase obligations is encouraged but not required. t/f

Answer 18

nature

amount

components

purchased

true

Question 19

On January 1, 20X1, Card Corp. signed a 3-year, noncancelable purchase contract, which allows Card to purchase up to 500,000 units of a computer part annually from Hart Supply Co. at $.10 per unit and guarantees a minimum annual purchase of 100,000 units. During 20X1, the part unexpectedly became obsolete. Card had 250,000 units of this inventory at December 31, 20X1, and believes these parts can be sold as scrap for $.02 per unit. What amount of probable loss from the purchase commitment should Card report in its 20X1 income statement?

$20,000

$16,000

$24,000

$8,000

Answer 19

$16,000

Minimum purchase commitment for 20X2 and 20X3
(100,000 units x $.10/u x 2 years)$20,000
Less scrap recovery (100,000 units x $.02 x 2 years 4,000
Probable loss from purchase commitment $16,000

Note: The question asks for the probable loss from purchase commitment (i.e., the loss for the remaining two years on the contract). The loss on the 250,000 units already in inventory is not considered part of this loss; it would be reported as an operating loss due to the write-down of inventory due to obsolescence.

Question 20

Conlon Co. is the plaintiff in a patent infringement case. Conlon has a high probability of a favorable outcome, and can reasonably estimate the amount of the settlement. What is the proper accounting treatment of the patent infringement case?

A gain contingency for the minimum estimated amount of the settlement

A gain contingency for the estimated probable settlement

No reporting is required at this time.

Disclosure in the notes only

Answer 20

Disclosure in the notes only

Since Conlon is the plaintiff (they are suing), a gain contingency exists. Gain contingencies are not recognized since they have not been realized (conservatism).

Question 21

On February 5, 20X1, an employee filed a $2,000,000 lawsuit against Steel Co. for damages suffered when one of Steel’s plants exploded on December 29, 20X0. 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, 20X0, balance sheet, what amount should Steel report as liability from lawsuit?

$2,000,000

$1,000,000

$500,000

$900,000

Answer 21

$500,000

FASB ASC 450-20-25 provides the following guidance when the estimated loss is in a range of values: When no amount within the range is a better estimate than any other amount, it is required that the minimum amount in the range shall be accrued.

Thus, Steel Co. should report a liability from the lawsuit in the amount of $500,000, the minimum amount in the range.

Question 22

On September 12, 20X5, an employee filed a $1,500,000 lawsuit against Friedman Corporation for damages suffered when the employee was wrongfully dismissed from his employment in 20X3. Friedman’s legal counsel expects the company will lose the lawsuit.

They believe the actual loss will be between $750,000 and $1,250,000. In an effort to avoid a trial, the employee offered to settle the lawsuit for $1,100,000.

In its December 31, 20X5, balance sheet, what amount should Friedman report as liability from lawsuit?

$750,000

$1,500,000

$1,250,000

$1,100,000

Answer 22

$750,000

FASB ASC 450-20-25 provides the following guidance when the estimated loss is in a range of values: When no amount within the range is a better estimate than any other amount, it is required that the minimum amount in the range shall be accrued.

Thus, Friedman Corporation should report a liability from the lawsuit in the amount of $750,000, the minimum amount in the range.

Question 23

• During January of the current year, Haze Corp. won a litigation award for $15,000 which was tripled to $45,000 to include punitive damages.
• The defendant, who is financially stable, has appealed only the $30,000 punitive damages.
• Haze was awarded $50,000 in an unrelated suit it filed, which is being appealed by the defendant. Counsel is unable to estimate the outcome of these appeals.

In its current year financial statements, Haze should report what amount of pretax gain?

1. $15,000
2. $45,000
3. $50,000
4. $95,000

Answer 23

$15,000

Both of these lawsuits are gain contingencies, which are generally not recognized until it is virtually certain that there are rights to receive the amounts involved. Thus, the amounts that are yet to be received, and subject to the uncertainty of an appeal process, should not be recognized yet.

However, the $15,000 award that has not been appealed can be taken now as pretax gain.

Question 24

• 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. 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?

$25,000

$5,000

$0

$20,000

Answer 24

$5,000

Question 25

Examples of loss contingencies include the following:

a. Collectibility of receivables
b. Obligations related to product warranties
c. Risk of loss due to damage of enterprise property due to fire, explosion, or other hazard
d. Threat of expropriation of assets
e. Pending or threatened litigation
f. Guarantees of indebtedness of others

Answer 25

yeah

Question 26

On November 1, 20X1, Davis Co. discounted with recourse at 10% a 1-year, noninterest bearing, $20,500 note receivable maturing on January 31, 20X2. What amount of contingent liability for this note must Davis disclose in its financial statements for the year ending December 31, 20X1?

$20,333

$20,500

$20,000

$0

Answer 26

$20,500

“With recourse” means that the financial entity where the note was discounted can collect fully from Davis Co. in the event the maker does not honor the note.

Davis Co. should disclose the full amount ($20,500) of the note as a contingent liability in its December 31, 20X1, financial statements, because it is reasonably possible that Davis will have to make good on the note (FASB ASC 450-20-50-2).

Question 27

Most notes are ___on a with recourse basis, requiring the estimation and recognition of a recourse liability that is taken on, based on the possible cost of having to make payments on the note if the original payor does not.

The discounting is accounted for as a sale, with the difference between the “sales __” of the note and the ___amount of the net receivable transferred being recognized as a gain or loss.

If the discounting of the note does not qualify as a sale, the transaction is accounted for as a __.

Answer 27

discounted

carrying amount and sales price

borrowing

Question 28

• A cereal manufacturer (the entity) offers a Pirates of the Bahamas Alarm Clock to anyone who sends in $3.99 and UPC symbols from two of its specially marked boxes of cereal.
• The offer ends on December 31, 20X9. During 20X9, the entity sold 1,400,000 of its cereal boxes with the Alarm Clock offer. The company purchases the clocks from Pirates of the Bahamas Alarm Clock Company as orders come in and are processed.
• The clocks cost $4.50 each and the entity also pays $1.00 for shipping and handling.
• The entity estimates that 70% of the UPC symbols will be redeemed. By December 31, 20X9, 250,000 Alarm Clock orders had been received and processed.

What amount of liability should the entity report for this premium offer at December 31, 20X9?

$490,000

$362,400

$377,500

$739,900

Answer 28

$362,400

The liability relates to the clocks expected to be shipped after the end of 20X9. The total clocks estimated to be ordered is 490,000 (1,400,000 boxes of cereal sold × 70% redemption rate = 980,000 UPC symbols expected to be redeemed; 980,000 UPC symbols ÷ 2 UPC symbols per clock = 490,000 clocks). Cost per clock is $1.51 ($4.50 purchase price + $1.00 shipping and handling – $3.99 received from customer = $1.51).

The total cost of all clocks equals $739,900 (490,000 × $1.51), which is also the total liability for the clocks. Since 250,000 of the clocks have already been sent to customers, the cost of those clocks is subtracted from the total liability to arrive at the year-end liability for the clocks of $362,400 ($739,000 – $377,500).

Question 29

• On January 2 of the current year, LTTI Co. entered into a three-year, noncancelable contract to buy up to 1,000,000 units of a product each year at $.10 per unit with a minimum annual guarantee purchase of 200,000 units.
• At year-end, LTTI had only purchased 80,000 units and decided to cancel sales of the product.

What amount should LTTI report as a loss related to the purchase commitment as of December 31 of the current year?

$8,000

$0

$52,000

$12,000

Answer 29

$52,000

LTTI had a purchase commitment for 600,000 units (200,000 × 3) and purchased 80,000 units. By canceling sales of the product, LTTI has a loss of $52,000 (520,000 units × .10).

Question 30

Vadis Co. sells appliances that include a 3-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 the machines are sold

When payments are made to the mechanic

Answer 30

When the machines are sold

Proper matching of revenues and expenses requires that if it is probable customers will make claims under warranties relating to goods that have been sold and a reasonable estimate of the costs can be made, the accrual method must be used.

Therefore, Vadis Co. should recognize its warranty costs when the machines are sold.

Question 31

Davidson Corporation is contending a tax judgment with the IRS. Davidson’s management can estimate the amount of loss that will occur if the judgment goes against Davidson. Davidson’s legal staff judges the probability of loss to be probable. In this situation, a loss contingency should be:

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.

Answer 31

disclosed and accrued as a liability.

• FASB ASC 450-20-25-2 requires accrual of a loss contingency when a loss is probable and the amount of such loss can be reasonably estimated.
• When a loss is not accrued because of the absence of one or both of these conditions, but a loss is reasonably possible, a loss contingency should be disclosed but not accrued. When the probability of a loss is remote, loss contingency is neither accrued nor disclosed.

Question 32

East Corp. manufactures stereo systems that carry a 2-year warranty against defects. Based on past experience, warranty costs are estimated at 4% of sales for the warranty period. During 20X1, stereo system sales totaled $3,000,000, and warranty costs of $67,500 were incurred.

In its income statement for the year ending December 31, 20X1, East should report warranty expense of:

$67,500.

$60,000.

$120,000.

$52,500.

Answer 32

$120,000.

Question 33

In October 20X2, Hake paid $375,000 to a former employee to settle a lawsuit out of court. The lawsuit had been filed in 20X1, and on December 31, 20X1, Hake had recorded a liability from lawsuit based on legal counsel’s estimate that the loss from the lawsuit would be between $250,000 and $750,000. Select the proper financial statement category for recording the gain or loss upon settlement of the lawsuit.

Nonoperating revenue and gains

Prior-period adjustment to beginning retained earnings

Income from continuing operations

Cumulative effect of change in accounting principle

Answer 33

Income from continuing operations

The gain or loss from the settlement of the lawsuit would properly be included in income from continuing operations.

Question 34

Which of the following information about threatened litigation should not be considered to determine whether an accrual is appropriate prior to an issuance of a company’s financial statements?

The period in which the threatened litigation became known to management

The degree of probability of an unfavorable outcome

The period in which the underlying cause of the threatened litigation occurred

The ability to make a reasonable estimate of the amount of loss

Answer 34

The period in which the threatened litigation became known to management

Proper accounting for loss contingencies (including pending or threatened litigation) requires an assessment of the probability that a future event or events will confirm a loss or asset impairment or the incurrence of a liability as of the date of the financial statements (not when management becomes aware of the event).

Loss contingencies are only accrued if both (1) it is probable that there will be an unfavorable (i.e., loss) outcome and (2) the amount can be reasonably estimated.

Question 35

Loss contingencies are only accrued if both (1) it is ___that there will be an unfavorable (i.e., loss) outcome and (2) the amount can be reasonably ___.

Answer 35

probable , estimated

Question 36

A company was notified it was being sued for damages by a customer. After the company’s attorneys evaluated the customer’s claim, it was determined that the amount of loss could be reasonably estimated.

The attorneys believe it is reasonably possible the company will have to pay the damages. The company:

1. should record an entry that debits a loss account and credits a liability and disclose the nature of the lawsuit in the financial statement footnotes.
2. should record an entry that debits a loss account and credits a liability but does not need to provide any disclosure in the financial statement notes.
3. does not need to report any information about the lawsuit in the financial statements or in the financial statement notes.
4. should disclose the nature of the lawsuit in the financial statement footnotes.

Answer 36

should disclose the nature of the lawsuit in the financial statement footnotes.

1. There are three categories of likelihood for contingent liabilities: probable, reasonably possible, and remote.
2. The accounting treatment depends on the likelihood and whether or not the amount of the loss can be reasonably estimated.
3. Since this contingent liability is reasonable possible, it should not be accrued in a journal entry but rather disclosed in the financial statement footnotes.

Question 37

There are three categories of likelihood for contingent liabilities:

Answer 37

probable, reasonably possible, and remote.

Question 38

Green Co. was preparing its year-end financial statements. Green had a pending lawsuit against a competitor for $5,000,000 in damages. Green’s attorneys indicate that obtaining a favorable judgment was probable and the amount of damages is reasonably estimated. Green incurred $100,000 in legal fees. The income tax rate was 30%. What amount, if any, should Green recognize as a contingency gain in its financial statements?

$3,500,000

$3,430,000

$0

$4,900,000

Answer 38

$0

Gain contingencies are not recognized since this would be the recognition of revenue prior to realization.

Question 39

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

$0

$20 million expense

$15 million income

Answer 39

$0

If the possibility that a company will be required to pay a contingent liability is reasonably possible, the liability is not required to accrue the liability. However, the nature of the liability and an estimate of the loss (or range of loss) must be disclosed. If it is probable that the company will acquire assets in the future due to the contingency, the gain cannot be recognized.

In this problem, the “reasonably possible” loss will not be accrued, only disclosed. The contingent gain cannot be accrued.

Question 40

• During 20X1, Haft Co. became involved in a tax dispute with the IRS. On December 31, 20X1, Haft’s tax advisor believed that an unfavorable outcome was probable.
• A reasonable estimate of additional taxes was $200,000 but could be as much as $300,000.
• After the 20X1 financial statements were issued, Haft received and accepted an IRS settlement offer of $275,000.

What amount of accrued liability should Haft have reported in its December 31, 20X1, balance sheet?

$200,000

$275,000

$250,000

$300,000

Answer 40

$200,000

FASB ASC 450-20-25-2 requires accrual of a loss contingency if “it is probable that an asset had been impaired or a liability had been incurred” and the loss amount can be reasonably estimated at balance sheet date.

Haft should have reported an accrued liability of $200,000, the amount of the reasonable estimate of additional taxes.

If a range of loss can be estimated, the best estimate within the range is accrued. If no amount within the range is a better estimate than any other amount, the minimum amount is accrued and the estimated range is disclosed.

Question 41

Paxton Co. signed contracts for the purchase of raw materials to be executed the following year at a firm price of $5 million. The market price of the materials dropped to $3 million on December 31. What amount should Paxton record as an estimated liability on purchase commitments as of December 31?

$0

$5,000,000

$3,000,000

$2,000,000

Answer 41

$2,000,000

As this loss is probable and the amount of the loss can be reasonably estimated, a $2,000,000 liability should be recognized as of December 31.

Question 42

Tableau Company manufactures hot water heater systems that carry a 2-year warranty against defects. Based on past experience, warranty costs are estimated at 2.5% of sales for the warranty period. During 20X9, hot water heater system sales totaled $2,600,000, and warranty costs of $31,300 were incurred. In its income statement for the year ending December 31, 20X9, Tableau should report warranty expense of:

$60,000.

$65,000.

$33,700.

$31,300.

Answer 42

$65,000.

Question 43

Answer 43

$14,250

Estimated warranty expense (20X1 sales) = .06 x $150,000 = $ 9,000
Estimated warranty expense (20X2 sales) = .06 x $250,000 = 15,000
Total estimated warranty expense $24,000
Less actual warranty expenditures 9,750
Estimated warranty liability on December 31, 20X2 $14,250

Question 44

Tableau Company manufactures hot water heater systems that carry a 2-year warranty against defects. Based on past experience, warranty costs are estimated at 2.5% of sales for the warranty period. During 20X9, hot-water heater system sales totaled $2,600,000, and warranty costs of $31,300 were incurred.

In its balance sheet at December 31, 20X9, Tableau should report warranty liability of:

$33,700.

$65,000.

$31,300.

$60,000.

Answer 44

$33,700.

Question 45

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 and accrued as a liability.

neither accrued as a liability nor disclosed.

accrued as a liability but not disclosed.

disclosed but not accrued as a liability.

Answer 45

disclosed but not accrued as a liability.

FASB ASC 450-20-25-2 requires accrual of a loss contingency when a loss is probable and the amount of such loss can be reasonably estimated.

When a loss is not accrued because of the absence of one or both of these conditions, but a loss is reasonably possible, a loss contingency should be disclosed but not accrued.

Question 46

What is the underlying concept governing the generally accepted accounting principles pertaining to recording gain contingencies?

Conservatism

Consistency

Relevance

Reliability

Answer 46

Conservatism

• Conservatism is gone now and in the future, but it was still the basis for this rule when the rule was decided upon, and the rule is still in effect.
• Future rules will not be based on conservatism, but the past rules were, and many are still in effect (e.g., lower of cost or market).
• A change in a concepts statement (Statement of Financial Accounting Concepts) does not change the rule, and does not change the basis for it.