In
preparing Sahoto Corporation's December 31, 2011 financial statements under
private enterprise GAAP, the vice-president, finance, is trying to determine
the proper accounting treatment for each of the following situations.
1.
As a result of uninsured accidents during the year, personal injury suits for
$350,000 and $60,000 have been filed against the company. It is the judgment of
Sahoto's legal counsel that an unfavorable outcome is unlikely in the $60,000
case but that an unfavorable verdict for approximately $225,000 is likely in
the $350,000 case.
2.
In early 2011, Sahoto received notice from the provincial environment ministry
that a site the company had been using to dispose of waste was considered
toxic, and that Sahoto would be held responsible for its cleanup under
provincial legislation. The vice-president, finance, discussed the situation
over coffee with the vice-president, engineering. The engineer stated that it
would take up to three years to determine the best way to remediate the site
and that the cost would be considerable, perhaps as much as $500,000 to $2
million or more. The engineering vice president advocates recognizing at least
the minimum estimate of $500,000 in the current year's financial statements,
while the financial vice-president advocates just disclosing the situation and
the inability to estimate the cost in a note to the financial statements.
3.
Sahoto Corporation owns a foreign subsidiary that has a carrying amount of
$5,725,000 and an estimated fair value of $8.7 million. The foreign government
has communicated to Sahoto its intention to expropriate the assets and business
of all foreign investors. On the basis of settlements other firms have received
from this same country, Sahoto expects to receive 40% of the fair value of its
properties as a final settlement.
4.
Sahoto's chemical product division consists of five plants and is un-insurable
because of the special risk of injury to employees and losses due to fire and
explosion. The year 2011 is considered one of the safest (luckiest) in the division's
history because there were no losses due to injury or casualty. Having suffered
an average of three casualties a year during the rest of the past decade
(ranging from $60,000 to $700,000), management is certain that next year the
company will not be so fortunate.
Instructions
(a)
Prepare the journal entries that should be recorded as at December 31, 2011, to
recognize each of the situations above.
(b)
Indicate what should be reported relative to each situation in the financial
statements and accompanying notes. Explain why.
(c)
Are there any ethical issues involved in accounting for contingencies?
(a)
|
1.
|
Loss from Uninsured Accident.................................
|
225,000
|
|
|
|
Liability
for Uninsured
Accident.......................................................
|
|
225,000
|
|
|
|
|
|
|
2.
|
Loss Due to Environmental Clean-up....................
|
500,000
|
|
|
|
Liability
for Environmental
Clean-up.......................................................
|
|
500,000
|
|
|
|
|
|
|
3.
|
Loss Due to Expropriation.........................................
|
2,245,000
|
|
|
|
Allowance
for Expropriation.........................
|
|
2,245,000
|
|
|
[$5,725,000 – (40% X $8,700,000)]
|
|
|
|
|
|
|
|
|
4.
|
No entry required.
|
|
|
(b)
1.
A
loss and a liability have been recorded in the first case because (i)
information is available prior to the issuance of the financial statements that
indicates it is likely that a liability had been incurred at the date of the
financial statements and (ii) the amount is reasonably estimable. That is, the
occurrence of the uninsured accidents during the year plus the outstanding
injury suits and the legal counsel’s estimate of probable loss required
recognition of a loss contingency.
|
|
No journal
entry is recorded in the case of the $60,000 injury suit since it is
considered unlikely that a liability has been incurred at the date of the
financial statements. If the amount were considered material it would be
desirable to disclose the existence of the lawsuit in the notes to the
financial statements.
|
|
2.
|
A loss and
a liability have been recorded because information is available prior to the
issuance of the financial statements that indicates it is likely that a
liability had been incurred at the date of the financial statements. Where a
range of possible amounts is determined and no one amount within the range
is more likely than another, the bottom of the range is usually accrued with
the amount of the remaining exposure disclosed in the notes.
|
|
|
3.
|
An entry
to record a loss and establish an allowance due to threat of expropriation
is necessary because the expropriation is imminent as evidenced by the
foreign government’s communicated intent to expropriate and the prior
settlements for properties already expropriated. That is, enough evidence
exists to reasonably estimate the amount of the probable loss resulting from
impairment of assets at the balance sheet date. The amount of the loss is
measured by the amount that the carrying amount of the assets exceeds the
expected compensation. At the time the expropriation occurs, the related
assets are written off against the allowance account. In this problem, we
established a valuation account because certain specific assets were
impaired. A valuation account was established rather than a liability
account because the net realizable value of the assets affected has
decreased. A more appropriate presentation would, therefore, be provided for
balance sheet purposes on the realizable value of the assets. It does not
seem appropriate at this point to write off the assets involved because it
may be difficult to determine all the specific assets involved, and because
the assets still have not been expropriated.
|
|
|
4.
|
Even
though Sahoto’s chemical product division is un-insurable due to high risk
and has sustained repeated losses in the past, as of the balance sheet date
no assets have been impaired or liabilities incurred nor is an amount
reasonably estimable. Therefore, this situation does not satisfy the
criteria for recognition of a loss contingency. Also, unless a casualty has
occurred or there is some other evidence to indicate impairment of an asset
prior to the issuance of the financial statements, there is no disclosure
required relative to a loss contingency. The absence of insurance does not
of itself result in the impairment of assets or the incurrence of
liabilities. Expected future injuries to others or damage to the property of
others, even if the amount is reasonably estimable, does not require
recording a loss or a liability. The cause for loss or litigation or claim
must have occurred on or prior to the balance sheet date and the amount of
the loss must be reasonably estimable in order for a loss contingency to be
recorded. Disclosure is required when one or both of the criteria for a loss
contingency are not satisfied and there is a reasonable possibility that a
liability may have been incurred or an asset impaired, or, it is probable
that a claim will be asserted and there is a reasonable possibility of an unfavorable
outcome.
|
|
(c) In
contingencies related to legal proceedings, the accrual for contingencies and
the related disclosure can be construed as an admission of guilt and could
weaken the company’s position. Company’s management has to balance the need for
full disclosure with the need for careful management of the legal proceedings
and protecting shareholder’s interests by avoiding costly lawsuit damages. The
ethical issues also involve the interpretation of terms such as “likely” and
“reasonably estimable” in determining when and how much is shown on financial
statements.
