Question

Sell-Soft is the defendant in numerous lawsuits claiming unfair trade practices. SellSoft has strong incentives not to disclose these contingent liabilities. However, GAAP requires that companies report their contingent liabilities.

Requirements

1. Why would a company prefer not to disclose its contingent liabilities?
2. Describe how a bank could be harmed if a company seeking a loan did not disclose its contingent liabilities.
3. What ethical tightrope must companies walk when they report contingent liabilities?

Short answer

1. The company cast a shadow on the business and created a negative impression.
2. The bank may view the company as low-risk if the contingent liability is not reported.
3. The ethical tightrope consists of the company acting truthfully and not deliberately misrepresenting the often complex situations.

Step-by-step solution

Meaning of GAAP

GAAP is an acronym for "Generally Accepted Accounting Principles," a collection of accounting rules and industry practices created over time. Organizations utilize it to arrange their financial data into accounting records appropriately, summarize the accounting data into financial statements, and reveal specific supporting data.

(1) Reason for which the company prefers not to disclose its contingent liabilities.

A corporation would prefer not to reveal its contingent liabilities as they throw a shadow over the firm and provide a wrong impression. They also identify potential future issues that can hurt the business's financial situation and make it more challenging to borrow money or recruit investors. Additionally, revealing the existence of a lawsuit may occasionally compromise its success. If the plaintiff or the jury learns of this information, they could conclude that the defendant accepts responsibility for the incident and anticipates losing the lawsuit.

(2) Explaining how a bank could be harmed if a company seeking a loan did not disclose its contingent liabilities.

A corporation runs the risk of a contingent obligation. The bank can consider the firm low risk if the contingent liability is not disclosed. As a result, the bank can decide to offer loans with low-interest rates and flexible repayment periods. The bank might not have granted the loan if it had known about the prospective liabilities. Another possibility is that the bank demanded a higher interest rate or stricter payment conditions. In the worst-case scenario, a bank may suffer if the firm cannot pay back the loan that the bank gave it based on inaccurate or insufficient information.

(3) Explaining the ethical tightrope that must companies walk when they report contingent liabilities

Reporting contingent liabilities frequently relies on an individual's subjective assessment of whether a scenario is unlikely, improbable, or likely. A business may have compelling reasons to slant judgment in one direction. Acting in good faith and without purposefully misrepresenting frequently complex situations yet using fair assessment, frequently in the face of intense pressure to falsify the truth, is the ethical tightrope.