Question

E13.13 (LO 3) (Contingencies) Presented below are three independent situations. Answer the question at the end of each situation.

 1. During 2020, Salt-n-Pepa Inc. became involved in a tax dispute with the IRS. Salt-n-Pepa's attorneys have indicated that they believe it is probable that Salt-n-Pepa will lose this dispute. They also believe that Salt-n-Pepa will have to pay the IRS between $900,000 and $1,400,000. After the 2020 financial statements were issued, the case was settled with the IRS for $1,200,000. What amount, if any, should be reported as a liability for this contingency as of December 31, 2020?

 2. On October 1, 2020, Jackson Chemical was identified as a potentially responsible party by the Environmental Protection Agency. Jackson's management along with its counsel have concluded that it is probable that Jackson will be responsible for damages, and a reasonable estimate of these damages is $5,000,000. Jackson's insurance policy of $9,000,000 has a deductible clause of $500,000. How should Jackson Chemical report this information in its financial statements at December 31, 2020?

 3. Etheridge Inc. had a manufacturing plant in Sudan, which was destroyed in the civil war. It is not certain who will compensate Etheridge for this destruction, but Etheridge has been assured by governmental officials that it will receive a definite amount for this plant. The amount of the compensation will be less than the fair value of the plant, but more than its book value. How should the contingency be reported in the financial statements of Etheridge Inc.? 

Answer 1

Part 1

Contingency liability = $900,000

According to FASB, if it is possible to get better estimated from the range of expected loss then that amount is considered to be accrued and in case of no better estimate, the amount at the lowest end of the range is considered to be accrued whereas the amount at the highest end is to be disclosed. Hence, the liability of $900000 is reported by Salt-n-Pepa Inc. at December 31, 2020.

Part 2

Loss accrued = $5,000,000

The potential insurance recovery is considered as a gain contingency and gain contingency is not recorded until it is actually received.

Part 3

No contingency should be reported in the financial statements of Etheridge Inc.

The amount that will be received is going to be higher than the book value of the plant and thus it is considered a gain contingency. Gain contingency is not recorded until it is actually received. It is just disclosed.

Answer 2

(1)

As per FASB, when based on a given range on contingency that may occur for reasons such as DISPUTES and a particular amount within the given range is very likely to become a liability than such amount should be accrued. However when such an estimate of a particular amount within the given range cannot be made than the lowest amount of the given range of possible loss is accrued. A disclosure is also made for the highest amount of the possible amount but it is not accrued. Since in the given case there is no such estimated amount within the given range of expected loss, therefore Salt-n-Pepa Inc should a report a liability of lowest amount of the given range which is $900000 as of December 31, 2020

(2)

Since Jackson's management along with it's counsel have concluded the probable loss for damages to be paid and also have made a reasonable estimate of $5000000, therefore Loss of $5000000 should be accrued by Jackson chemical in it's financial statements of December 31, 2020. The amount that could be recovered from insurance cannot be reasonable estimated and therefore should not be recorded until actually received

(3)

This situation where Etheridge Inc is assured by government that it will receive a definite amount for the plant which will be more than it's book value results in a contingent gain for Etheridge Inc. Such gain contingencies should not be recorded in books of accounts but since the chances of such contingency becoming a reality is very high as is assured by government therefore an appropriate disclosure should be made.