D.2. Contingencies

77. On January 17, 2011, an explosion occurred at a Sims Co. plant causing

extensive property damage to area buildings. Although no claims had yet been asserted

against Sims by March 10, 2011, Sims’ management and counsel concluded that it is

likely that claims will be asserted and that it is reasonably possible Sims will be

responsible for damages. Sims’ management believed that $1,250,000 would be a

reasonable estimate of its liability. Sims’ $5,000,000 comprehensive public liability

policy has a $250,000 deductible clause. In Sims’ December 31, 2010 financial

statements, which were issued on March 25, 2011, how should this item be reported?

a. As an accrued liability of $250,000.

b. As a footnote disclosure indicating the possible loss of $250,000.

c. As a footnote disclosure indicating the possible loss of $1,250,000.

d. No footnote disclosure or accrual is necessary.

78. Brite Corp. had the following liabilities at December 31, 2011:

Accounts payable $55,000 Unsecured notes, 8%, due 7/1/12 400,000 Accrued expenses

35,000 Contingent liability 450,000 Deferred income tax liability 25,000 Senior bonds,

7%, due 3/31/12 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 2013, 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 2013.

What amount should Brite report in its December 31, 2011 balance sheet for

current liabilities?

a. $ 515,000

b. $ 940,000

c. $1,490,000

d. $1,515,000

79. On February 5, 2012, an employee filed a $2,000,000 lawsuit against Steel Co.

for damages suffered when one of Steel’s plants exploded on December 29, 2011. 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, 2011

balance sheet, what amount should Steel report as liability from lawsuit?

a. $2,000,000

b. $1,000,000

c. $ 900,000

d. $ 500,000

80. On November 5, 2011, a Dunn Corp. truck was in an accident with an auto

driven by Bell. Dunn received notice on January 12, 2012, of a lawsuit for $700,000

damages for personal injuries suffered by Bell. Dunn Corp.’s counsel believes it is

probable that Bell will be awarded an estimated amount in the range between $200,000

and $450,000, and that $300,000 is a better estimate of potential liability than any other

amount. Dunn’s accounting year ends on December 31, and the 2011 financial statements

were issued on March 2, 2012. What amount of loss should Dunn accrue at December 31,

2011?

a. $0

b. $200,000

c. $300,000

d. $450,000

81. During 2011, Haft Co. became involved in a tax dispute with the IRS. At

December 31, 2011, 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 2011 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, 2011 balance sheet?

a. $200,000

b. $250,000

c. $275,000

d. $300,000

82. 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

a. Disclosed but not accrued as a liability.

b. Disclosed and accrued as a liability.

c. Accrued as a liability but not disclosed.

d. Neither accrued as a liability nor disclosed.

83. 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 2011 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 2011 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.

84. In 2010, a personal injury lawsuit was brought against Halsey Co. Based on

counsel’s estimate, Halsey reported a $50,000 liability in its December 31, 2010 balance

sheet. In November 2011, 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, 2011

balance sheet, Halsey should report what amounts of asset and liability related to these

legal actions?

Asset Liability a. $30,000 $50,000 b. $30,000 $0 c. $0 $20,000 d. $0 $0

85.

During January 2011, Haze Corp. won a litigation award for $15,000 that 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 2011 financial statements, Haze should report what

amount of pretax gain?

a. $15,000

b. $45,000

c. $50,000

d. $95,000

86. In May 2007 Caso Co. filed suit against Wayne, Inc. seeking $1,900,000

damages for patent infringement. A court verdict in November 2011 awarded Caso

$1,500,000 in damages, but Wayne’s appeal is not expected to be decided before 2013.

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, 2011?

a. $0

b. $ 800,000

c. $1,000,000

d. $1,500,000

87. During 2011, Smith Co. filed suit against West, Inc. seeking damages for

patent infringement. At December 31, 2011, 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 2012, Smith was awarded $100,000 and received full payment thereof. In its 2011

financial statements, issued in February 2012 how should this award be reported?

a. As a receivable and revenue of $100,000.

b. As a receivable and deferred revenue of $100,000.

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

d. As a disclosure of a contingent gain of an undetermined amount in the range of

$75,000 to $150,000.

88. In 2011, a contract dispute between Dollis Co. and Brooks Co. was submitted

to binding arbitration. In 2011, each party’s attorney indicated privately that the probable

award in Dollis’ favor could be reasonably estimated. In 2012, the arbitrator decided in

favor of Dollis. When should Dollis and Brooks recognize their respective gain and loss?

Dollis’ gain Brooks’ loss a. 2011 2011 b. 2011 2012 c. 2012 2011 d. 2012 2012

89. 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.

90. North Corp. has an employee benefit plan for compensated absences that

gives employees 10 paid vacation days and 10 paid sick days. Both vacation and sick

days can be carried over indefinitely. Employees can elect to receive payment in lieu of

vacation days; however, no payment is given for sick days not taken. At December 31,

2011, North’s unadjusted balance of liability for compensated absences was $21,000.

North estimated that there were 150 vacation days and 75 sick days available at

December 31, 2011. North’s employees earn an average of $100 per day. In its December

31, 2011 balance sheet, what amount of liability for compensated absences is North

required to report?

a. $36,000

b. $22,500

c. $21,000

d. $15,000

91. Ross Co. pays all salaried employees on a Monday for the five-day workweek

ended the previous Friday. The last payroll recorded for the year ended December 31,

2011, was for the week ended December 25, 2011. The payroll for the week ended

January 1, 2012, included regular weekly salaries of $80,000 and vacation pay of $25,000

for vacation time earned in 2011 not taken by December 31, 2011. Ross had accrued a

liability of $20,000 for vacation pay at December 31, 2010. In its December 31, 2011

balance sheet, what amount should Ross report as accrued salary and vacation pay?

a. $64,000

b. $68,000

c. $69,000

d. $89,000

92. Gavin Co. grants all employees two weeks of paid vacation for each full year

of employment. Unused vacation time can be accumulated and carried forward to

succeeding years and will be paid at the salaries in effect when vacations are taken or

when employment is terminated. There was no employee turnover in 2011. Additional

information relating to the year ended December 31, 2011, is as follows:

Liability for accumulated vacations at 12/31/10 $35,000 Pre-2011 accrued vacations

taken from 1/1/11 to 9/30/11 (the authorized period for vacations) 20,000 Vacations

earned for work in 2011 (adjusted to current rates) 30,000 Gavin granted a 10%

salary increase to all employees on October 1, 2011, its annual salary increase date. For

the year ended December 31, 2011, Gavin should report vacation pay expense of

a. $45,000

b. $33,500

c. $31,500

d. $30,000

93. At December 31, 2011, Taos Co. estimates that its employees have earned

vacation pay of $100,000. Employees will receive their vacation pay in 2012. Should

Taos accrue a liability at December 31, 2011, if the rights to this compensation

accumulated over time or if the rights are vested?

Accumulated Vested a. Yes No b. No No c. Yes Yes d. No Yes 94. If the

payment of employees’ compensation for future absences is probable, the amount can be

reasonably estimated, and the obligation relates to rights that accumulate, the

compensation should be

a. Accrued if attributable to employees’ services not already rendered.

b. Accrued if attributable to employees’ services already rendered.

c. Accrued if attributable to employees’ services whether already rendered or not.

d. Recognized when paid.

95. During 2010, Gum Co. introduced a new product carrying a two-year

warranty against defects. The estimated warranty costs related to dollar sales are 2%

within twelve months following the sale and 4% in the second twelve months following

the sale. Sales and actual warranty expenditures for the years ended December 31, 2010

and 2011, are as follows:

Sales Actual warranty expenditures 2010 $150,000 $2,250 2011 250,000 7,500

$400,000 $9,750 What amount should Gum report as estimated warranty liability in

its December 31, 2011 balance sheet?

a. $ 2,500

b. $ 4,250

c. $11,250

d. $14,250

96. 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?

a. Evenly over the life of the warranty.

b. When the service calls are performed.

c. When payments are made to the mechanic.

d. When the machines are sold.

97. Lute Corporation sells furnaces that include a three-year warranty. Lute can

contract with a third party to provide these warranty services. Lute elects the fair value

option for reporting financial liabilities. At what amount should Lute record the warranty

liability on the balance sheet?

a. The cost of expected warranty services.

b. The present value of expected warranty costs.

c. The fair value of the contract to settle the warranty services.

d. The fair value of the contract to settle less the cost to provide services.

98. Case Cereal Co. frequently distributes coupons to promote new products. On

October 1, 2011, 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, 2011, expiration date. It takes thirty 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, 2011, 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,

2011 balance sheet?

a. $35,000

b. $29,000

c. $25,000

d. $22,500

99. 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, 2010. Additional information for

2011 is as follows:

Stamp service revenue from stamps sold to licensees $4,000,000 Cost of redemptions

(stamps sold prior to 1/1/11) 2,750,000 If all the stamps sold in 2011 were presented

for redemption in 2012, the redemption cost would be $2,250,000. What amount should

Dunn report as a liability for stamp redemptions at December 31, 2011?

a. $7,250,000

b. $5,500,000

c. $5,050,000

d. $3,250,000

100. Chemrite Inc. reported a total asset retirement obligation of $350,000 in last

year’s balance sheet. This year, Chemrite acquired a new chemical manufacturing facility

subject to unconditional retirement obligations. Two measures of the obligation are the

discounted cash flow estimate of $82,000 and the undiscounted cash flow estimate of

$105,000. Accretion expense equaled $23,000. What amount should Chemrite report for

the asset retirement obligation in this year’s balance sheet?

a. $350,000

b. $373,000

c. $455,000

d. $478,000

77. (b) A loss contingency should be accrued if it is probable that a liability has

been incurred at the balance sheet date and the amount of the loss is reasonably estimable.

With respect to unfiled claims, the enterprise must consider both the probability that a

claim will be filed and the probability of an unfavorable outcome. Although it is probable

that claims will be asserted against Sims, it is only reasonably possible that the claims

will be successful. Therefore, this contingent liability should not be accrued, but should

be disclosed. The potential loss to be disclosed is $250,000, since the additional amount

above the deductible would be covered by the insurance policy, and therefore is not a loss

or liability for Sims.

78. (c) Current liabilities are obligations whose liquidation is reasonably expected

to require the use of current assets or the creation of other current liabilities. This means

that generally, current liabilities are the liabilities that are due within one year of the

balance sheet date. Clearly, accounts payable ($55,000) and accrued expenses ($35,000)

are current liabilities. Notes payable ($400,000) and bonds payable ($1,000,000) are

usually considered to be long-term, but the maturity dates given (7/1/12 and 3/1/12

respectively) indicate they are current liabilities at 12/31/11. The contingent liability

($450,000) and deferred tax liability ($25,000) will not be settled until 2013 and therefore

should be classified as long-term at 12/31/11. Thus, the 12/31/11 current liabilities total is

$1,490,000 as follows:

Accounts payable $ 55,000 Accrued expenses 35,000 Unsecured notes 8%—due 7/1/12

400,000 Senior bonds 7%—due 3/31/12 1,000,000 Total current liabilities $1,490,000

79. (d) The lawsuit damages must be accrued as a loss contingency because an

unfavorable outcome is probable and the amount of the loss is reasonably estimable.

When a range of possible loss exists, the best estimate within the range is accrued. When

no amount within the range is a better estimate than any other amount, the dollar amount

at the low end of the range is accrued (in this case, $500,000) and the dollar amount of

the high end of the range is disclosed.

80. (c) A loss contingency should be accrued if it is probable that a liability has

been incurred at the balance sheet date and the amount of the loss is reasonably

estimable. This loss must be accrued because it meets both criteria. Notice that even

though the lawsuit was not initiated until 1/12/12, the liability was incurred on 11/5/11

when the accident occurred. When some amount within an estimated range is a better

estimate than any other amount in the range, that amount is accrued. Therefore, a loss of

$300,000 should be accrued. If no amount within the range is a better estimate than any

other amount, the amount at the low end of the range is accrued and the amount at the

high end is disclosed.

81. (a) The additional tax liability must be accrued as a loss contingency because

an unfavorable outcome is probable and the amount of the loss is reasonably estimable.

Since $200,000 is the reasonable estimate, that amount should be accrued by debiting

Income Tax Expense and crediting Income Tax Payable. The possibility of the liability

being as high as $300,000 would be disclosed in the notes. The settlement offer of

$275,000 is not accrued at 12/31/11 because prior to financial statement issuance, Haft

was unaware of the offer, and $200,000 was the best estimate. In 2012, when the

settlement offer was accepted, Haft would record an additional $75,000 of expense and

liability.

82. (a) A loss contingency is accrued if it is probable that a liability has been

incurred at the balance sheet date and the amount of the loss is reasonably estimable. If

no accrual is made for a loss contingency because one or both of the conditions above are

not met, disclosure of the contingency shall be made when it is at least reasonably

possible that a loss was incurred. Therefore, this loss should be disclosed, but not accrued

as a liability.

83. (b) Invern’s appropriation of retained earnings for contingencies is merely a

reclassification of retained earnings on the balance sheet which tells the readers of the

financial statements that such amounts are generally not available to pay dividends. This

appropriation has no effect on the income statement. When a loss contingency is probable

(as in this instance) and reasonably estimable ($190,000 in this instance), accrual of the

loss is required. Therefore, Invern must accrue both a liability and an expense of

$190,000. Note that Invern will also reclassify $190,000 of appropriated retained

earnings into the “general” retained earnings.

84. (d) At 12/31/11, Halsey’s contingent liability of $50,000 is no longer probable

due to the favorable judgment and the inability to predict the outcome of the appeal.

Therefore, no liability should be reported in the balance sheet. Gain contingencies are not

reflected in the accounts until realized, so the $30,000 asset is not reported in the

12/31/11 balance sheet, either.

85. (a) Gain contingencies are not recognized in the income statement until

realized. As only $15,000 of the litigation awards has been resolved as of December 31,

2011, Haze should report only $15,000 as a gain in its 2011 financial statements.

86. (a) Gain contingencies are not reflected in the accounts until realized. Since

the case is unresolved at 12/31/11, none of this contingent gain should be recorded as

income in 2011. Adequate disclosure should be made of the gain contingency, but care

should be taken to avoid misleading implications as to the likelihood of realization.

87. (d) Gain contingencies are not reflected in the accounts until realized. Since

the case was unresolved at 12/31/11, none of this contingent gain can be recorded as a

receivable and/or revenue in 2011. Since the contingency is probable, it should be

disclosed along with the 12/31/11 estimate of a range of $75,000 to $150,000. A gain

contingency would not be accrued as a receivable. The amount disclosed should be the

range because all amounts within the range are considered equally likely.

88. (c) An estimated loss from a loss contingency shall be accrued by a charge to

income if both of the following conditions are met:

1. Information available indicates that it is probable that an asset has been impaired or

a liability has been incurred. 2. The amount of the loss can be reasonably estimated.

However, gain contingencies are only recognized when a specific event actually

occurs, not prior to the event, because to do so would recognize the gain prior to its

realization. Therefore, Brooks should recognize the loss in 2011 due to the fact that the

event is probable and can be reasonably estimated. Dollis, on the other hand, cannot

recognize the gain until 2012, the year they receive the actual award.

89. (a) Eagle Co. has a contingent liability where the possibility of loss is remote.

Loss contingencies are accrued when they are probable and reasonably estimable. All

others are disclosed unless remote. However, some contingencies, such as guarantees of

others’ debts, standby letters of credit by banks, and agreements to repurchase receivables,

are disclosed even if remote. Eagle’s contingent liability is not accrued, because it is not

probable. It is disclosed for two reasons: it is a guarantee of other’s debt, and it is a

related-party transaction.

90. (d) An accrual of a liability for future vacation pay is required if all the

conditions below are met.

1. Obligation arises from employee services already performed. 2. Obligation arises

from rights that vest or accumulate. 3. Payment is probable. 4. Amount can be

reasonably estimated. The criteria are met for the vacation pay (150 ×$100 =

$15,000), so North is required to report a $15,000 liability. The same criteria apply to

accrual of a liability for future sick pay, except that if sick pay benefits accumulate but

do not vest, accrual is permitted but not required because its payment is contingent

upon future employee sickness. Therefore, no liability is required for these sick pay

benefits (75 ×$100 = $7500). Note that the unadjusted balance of the liability account

($21,000) does not affect the computation of the required 12/31/11 liability.

91. (d) The week ended 1/1/12 included four days in 2011 and one day in 2012.

The pay due for this week won’t be paid until the following Monday (1/4/12). Therefore,

Ross has a liability for four days’ accrued salaries at 12/31/11 (4/5 ×$80,000 = $64,000).

The entire $25,000 of vacation pay is an accrued liability at 12/31/11 because it

represents vacation time earned by employees in 2011 but not taken by 12/31/11.

Therefore, the total accrued salary and vacation pay is $89,000 ($64,000 + $25,000).

92. (c) An employer is required to accrue a liability for employees’ rights to

receive compensation for future absences, such as vacations, when certain conditions are

met. The Statement does not, however, specify how such liabilities are to be measured.

Since vacation time is paid by Gavin Co. at the salaries in effect when vacations are taken

or when employment is terminated, Gavin adjusts its vacation liability and expense to

current salary levels. Gavin’s 2011 vacation pay expense consists of vacations earned for

work in 2011 (adjusted to current rates) of $30,000 plus the amount necessary to adjust

its pre-2011 vacation liability for the 10% salary increase. The amount of this adjustment

is equal to 10% of the preexisting liability balance at December 31, 2011 [($35,000 −

$20,000) ×10% = $1,500]. Therefore, total vacation pay expense for the period is equal

to $31,500 ($30,000 + $1,500).

93. (c) An employer shall accrue a liability for employees’ future absences if all

of the following conditions are met: (1) the employer’s obligation relates to employees’

service already rendered, (2) the employees’ rights vest or accumulate, (3) payment of

the compensation is probable, and (4) the amount can be reasonably estimated. All of

these conditions are met whether Taos Co.’s employees’ rights either accumulate or vest.

94. (b) Accrual of a liability for employees’ compensation for future absences is

required if all of the conditions below are met.

1. Obligation arises from employee services already performed. 2. Obligation arises

from rights that vest or accumulate. 3. Payment is probable. 4. Amount can be

reasonably estimated. 95. (d) The solutions approach is to set up a T-account for

warranty liability.

Each year warranty expense is estimated at 6% of sales and recorded by debiting

the expense account and crediting the liability. As warranty expenditures are made, the

liability is debited and cash is credited. Note that the total estimated warranty cost for

both years (2% + 4% = 6%) is recorded in the year of sale in compliance with the

matching principle.

96. (d) The warranty expense of $30 for each machine sold, although it will be

incurred over the three-year warranty period, is directly related to the sales revenue as an

integral and inseparable part of the sale and recognized at the time of the sale. The

warranty costs make their contribution to revenue in the year of sale by making the

product more attractive to the customer. Therefore, in accordance with the matching

principle, the warranty costs should be expensed when the machines are sold with a

corresponding credit to accrued liability. Answers (a) and (b) are incorrect; this is a sales

warranty approach in which the warranty is sold separately from the product. The

revenue is recognized on the straight-line basis and they are expensed as incurred.

Answer (c) is incorrect because this describes a cash basis method.

97. (c) Warranty services can be recorded at the fair value only if the contract can

be settled by a third party. Therefore, the fair value is considered the settlement amount

of the contract.

98. (a) Case expects 120,000 coupons to be redeemed at a total cost of $.50 per

coupon ($.45 + $.05). Therefore, total expected redemptions are $60,000 (120,000 ×

$.50). By 12/31/11, $25,000 has been paid on coupon redemptions, so a liability of

$35,000 must be established ($60,000 − $25,000). Note that this liability would include

both payments due for the 50,000 coupons on hand, and payments due on coupons to be

received within the first thirty days after the expiration date.

99. (c) Dunn records stamp service revenue and provides for the cost of

redemptions in the year stamps are sold. Therefore, Dunn’s entries are

To record sales of stamps Cash 4,000,000 Stamp service revenue 4,000,000 To

record cost of redemptions Liability for stamp reds. 2,750,000 Inventory 2,750,000 To

provide for cost of future redemptions Cost of redemptions 1,800,000 Liability for stamp

reds. (80% ×$2,250,000) 1,800,000 The 12/31/11 liability balance is $5,050,000

as shown below.

100. (c) The asset retirement obligation (ARO) is recorded at its fair value in the

period in which it is incurred. Subsequently, it is adjusted for revisions in estimates and

the passage of time. The beginning balance in the asset retirement obligation account is

$350,000. The fair value of the additional unconditional retirement obligations incurred

during the year was $82,000 and increases the ARO. The $23,000 accretion expense is

the expense recognized on the ARO due to the passage of time and will increase the ARO.

($350,000 + $82,000 + $23,000 = $455,000)