Question

Lincoln Chemicals became involved in investigations by the U.S. Environmental Protection Agency in regard to damages connected to waste disposal sites. Below are four possibilities regarding the timing of (A) the alleged damage caused by Lincoln, (B) an investigation by the EPA, (C) the EPA assessment of penalties, and (D) ultimate settlement. In each case, assume that Lincoln is unaware of any problem until an investigation is begun. Also assume that once the EPA investigation begins, it is probable that a damage assessment will ensue and that once an assessment is made by the EPA, it is reasonably possible that a determinable amount will be paid by Lincoln. Required: For each case, decide whether (a) a loss should be accrued in the financial statements with an explanatory note, (b) a disclosure note only should be provided, or (c) no disclosure is necessary. Case 1 Financial Statements Issued Fiscal Year Ends Case 2 C D Fiscal Year Ends Case 3 Financial Statements Issued Fiscal Year Ends Financial Statements Issued Case 4 Fiscal Year Ends Financial Statements Issued Case 1 Case 2 Case 3 Case 4

Answer 1

Before starting with the answer, I would like to first give a brief of what subsequent events are and how they are accounted :

First of all subsequent events are events which occur after the balance sheet date but before the date financial statements are issued by the management.

There are 2 types of subsequent events :

1. Adjusting events : These are the events occurring after the balance sheet date for which conditions were pre-existing as on the balance sheet date.

2. Non-Adjusting events : These are events occurring after the balance sheet date for which no conditions were existing as on the balance sheet date.

Accounting for Subsequent events : If the subsequent event is an adjusting event, then adjustments are required to be made in the financial statements along with an explanatory note. If it is a non-adjusting event, no adjustment is required in the financial statements, however disclosure should be made if such event occurs before the date on which financial statements are issued and is also material.

Now that we have understood the concept, we have answered the question below :

S. No.	Answer	Remarks
Case 1	(b) : a disclosure note only should be provided	This is a non-adjusting event as the alleged damage has been caused by the company after the balance sheet date, i.e., no conditions were pre-existing on the balance sheet and hence no adjustment is required in the financial statements. However this is a significant event which has occured before the financial statements are issued and the ultimate settlement has also been concluded before issuance of financial statements and hence a discloure note is required to be given in the financial statements
Case 2	(b) : a disclosure note only should be provided	Even though it is an adjusting event, only investigation by EPA has begun till the date financial statements are issued and hence even though it is probable that the damage assessment will ensue, the outcome of the case and the amount of liability cannot be accurately determined and hence it should be disclosed as contingent liabilty in the financial statements.
Case 3	(a) : a loss should be accrued in the financial statements with an explanatory note	Loss should be accrued because : 1. It is an adjusting event since the conditions were pre-existing on the balance sheet date. 2. Ultimate settlement has been done before issuance of financial statements.
Case 4	(c) : no disclosure is necessary	Since the investigation has begun only after the issuance of financial statements, no disclosure is necessary.
Note : There can also be a different opinion with regards to the fact that (B) event ("investigation by EPA has begun") should have happened before the balance sheet date for the event to be an adjusting event. However, in my opinion if the alleged damage was caused by the company before the balance sheet date, that means the conditions were pre-existing on balance sheet date and the question has been answered accordingly. It is really a subjective matter and also depends on the auditor's opinion and hence the question could have been answered while taking that assumption.