Dungannon
Enterprises Ltd. sells a specialty part that is used in widescreen televisions
and provides the ultimate in screen clarity. To promote sales of its product,
Dungannon initiated a program with some of its smaller customers.
In
exchange for making Dungannon their exclusive supplier, Dungannon guarantees
these customers to their creditors so that Dungannon will assume the customers'
long-term debt in the event of non-payment to the creditors. In addition to
charging for parts, Dungannon also charges a fee to customers who take the
guarantee program, and bases the fee on the time frame that the guarantee
covers, which is typically three years. In the current fiscal year, these fees
amounted to $30,000 for the three-year coverage period.
Six
months before Dungannon's fiscal year end, one of its customers, Hutter Corp.,
began to experience financial dif ficulties and missed two months of mortgage
payments. Hutter's lender then called on Dungannon to make the mortgage
payments. At its fiscal year end on December 31, 2011, Dungannon had recorded a
receivable of $15,000 related to the payments made by Dungannon on Hutter's
behalf. Hutter owes the lender an additional $30,000 at this point. The lender
is contemplating putting a lien on Hutter's assets that were pledged as
collateral for the loans but the collateral involves rights on development of
new state-of-the-art three-dimensional television technology that is still
unproven. Dungannon follows private enterprise GAAP.
Instructions
(a)
Prepare all required journal entries and adjusting entries on Dungannon's books
to recognize the transactions and events described above.
(b)
Identify any disclosures that must be made as a result of this information and
prepare the note disclosure for Dungannon for the period ended December 31,
2011.
(a)
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Cash ...............................................................................................
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30,000
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Unearned
Guarantee Revenue.......................................
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30,000
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Accounts Receivable.....................................................................
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15,000
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Cash.....................................................................................
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15,000
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Unearned Guarantee Revenue...................................................
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10,000
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Guarantee
Revenue..........................................................
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10,000
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($30,000 ¸ 3)
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Loss on Guarantees*.....................................................................
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30,000
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Liability
for Guarantee.......................................................
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30,000
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* This entry
is based on management’s determination of the likelihood of loss in providing
guarantees for Hutter. Since the collateral for the loan involves rights on
unproven technology, it appears that the possibility of loss is likely.
Accounts receivable was not debited since Dungannon have not yet made payment
on Hutter’s debt. They do not have a
balance owing from Hutter.
The Guarantee
Revenue has been recognized on a straight-line basis. Company management may
consider another basis more appropriate, such as an amount proportionate to the
amount of debt being covered by the guarantee.
Dungannon
will also need to assess the collectibility of the receivable and include it in
its bad debts expense and allowance for doubtful accounts determination as part
of its adjusting entries. In particular, since the additional exposure to loss
of $30,000 for Hutter’s liabilities involves rights on unproven technology, the
estimate of bad debts expense on the outstanding receivable appears likely.
(b) Dungannon
needs to disclose the following information relating to its guarantees:
- The nature of the guarantee, how
it arose, and circumstances that require the guarantor to perform under
the guarantee;
- The maximum potential amount of
future payments that the guarantor could be required to make, without any
reduction for recoverable amounts;
- The nature and extent of any
recourse provisions or collaterial held;
- The carrying amount of the
liability, if any.
Disclosure in Dungannon’s notes:
The Company
provides guarantees to certain customers whereby to assume their long-term debt
in the event of non-payment to their creditors. The guarantee arrangement
covers a three-year period from the date of the agreement. The maximum
potential amount of future payments that the Company could be required to make
is $XXXXX. The Company does not have any recourse provisions or collateral
against the current and potential liabilities arising from these guarantees. The Company has made payments under the
guarantee for $15,000 and has accrued an additional $30,000 for the same
customer. The possibility of further
loss from this customer cannot be determined at this point. All other customers
under guarantee have honoured their debt arrangements and the Company believes
the possibility of loss under guarantees to these other customers to be
unlikely.
