Question

(Contingencies) Presented below are three independent situations. Answer the question at the end of each situation:

1. During 2017, 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 2017 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, 2017?

2. On October 1, 2017, Alan 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 Alan Jackson Chemical report this information in its financial statements at December 31, 2017?

3. Melissa 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.?

Short answer

1. $900,000will be reported as contingency liability.
2. $5,000,000will get accrued as a contingent liability.
3. Excess of the amount received over the book value will be reported as contingency gain.

Step-by-step solution

Definition of Contingency Liability

Occurrence of liability which is based on the happening of a uncertain event or transaction in the future is known as contingency liability. It is reported only when accountant are able to measure the liability in monetary term reasonably.

Amount reported as contingency liability as of December 31, 2017

According to the principles stated by FASB, the business entity must record the best estimate of the liability in the contingency. If a range of liability is estimated and there is no better estimate, the business entity must accrue the lower end of the range of liability estimated. Therefore, Salt-n-Pepa Inc would report a contingency of $900,000 on 31 December 2017.

Reporting by Alan Jackson in the financial statements

The business entity has a reasonable estimate of the damages of $5,000,000. Therefore, $5,000,000 must be accrued as contingency liability. The amount that will be recovered from the insurance is the gain contingency that will be recorded when it is received.

Reporting contingency in the financial statement

This will be reported as contingency gain because the business entity has estimated that the amount received will be more than the book value of the plant. Such gain is not recorded when the probability of the gain is high, instead, it must be recorded when it is received.