The two basic requirements for the accrual of a loss contingency are supported by several basic concepts of accounting. Four of these concepts are periodicity (time periods), measurement, objectivity, and relevance.
Briefly discuss how the two basic requirements for accrual of a loss contingency relate to the four concepts listed above.
Angela Company is a manufacturer of toys. During the year, the following situations arose:
1. A safety hazard related to one of its toy products was discovered. It is considered probable that liabilities have been incurred. Based on past experience, a reasonable estimate of the amount of loss can be made.
2. One of the firm’s small warehouses is located on the bank of a river and can no longer be insured against flood losses. No flood losses occurred after the date the insurance became unavailable.
3. This year, Angela began promoting a new toy by including a coupon, redeemable for a movie ticket, in each toy’s carton. The movie ticket, which cost Angela $2, is purchased in advance and then mailed to the customer when Angela receives the coupon. Based on past experience, Angela estimated that 60 percent of the coupons would be redeemed. Forty percent of the coupons would be actually redeemed this year, and the remaining 20 percent of the coupons were expected to be redeemed next year.
a. How should Angela report the safety hazard? Why? Do not discuss deferred
b. How should Angela report the uninsured flood risk? Why?
c. How should Angela account for the toy promotion campaign in this year?
The following three independent sets of facts relate to (1) the possible accrual or (2) the possible disclosure by other means of a loss contingency.
A company offers a one-way warranty for the product that it manufactures. A history of warranty claims has been compiled, and the probable amount of claims related to sales for a given period can be determined.
Following the date of a set of financial statements, but before the issuance of the financial statements, a company enters into a contract that will probably result in a significant loss to the company. The amount of the loss can be reasonably estimated.
A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by the company’s vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $2,000. During the period covered by the financial statements, no accidents involving the company’s vehicles resulted in injury to others.
Discuss the accrual of a loss contingency and/or type of disclosure necessary (if any) and the reason(s) why such a disclosure is appropriate for each of the three independent sets of facts above. Complete your response to each situation before proceeding to the next situation.
Whiley Company issued a $100,000, five-year, 10%note to Security Company on January 2, 2009. Interest was to be paid annually each December 31st. The stated rate of interest reflected the market rate of interest on similar notes.
Whiley made the first interest payment on December 31, 2009. Due to financial difficulties, the firm was unable to pay any interest on December 31, 2010.
Security agreed to the following terms:
1. The $100,000 principal would be payable in five equal installments, beginning December 31, 2011.
2. The accrued interest at December 31, 2010, would be forgiven.
3. Whiley would be required to make no other payments.
Because of the risk associated with the note, it has no determinable fair value. The note is secured by equipment having a fair value of $80,000 at December 31, 2010. The present value of the fi ve equal installments discounted at 10% is $75,815.
a. Under current GAAP, at which amount would Whiley report the restructured liability at December 31, 2010? Explain. How much gain would Whiley recognize in its income statement for 2010? Explain. How much interest expense would Whiley recognize in 2011? Explain.
b. Under current GAAP, what alternatives does Security have for reporting the restructured receivable? Explain. How would each alternative affect the 2010 income statement and future interest revenue? Explain.
c. Discuss the pros and cons of the alternatives in (b) and compare them to the prior GAAP treatment (treatment that was reciprocal to the debtor).
d. If debtors were allowed to record the restructuring agreement in a manner similar to creditors, what would be the incremental effect (difference between what would be reported in this case and current GAAP for debtors) on Whiley’s financial statements, debt-to-equity ratio, and EPS for 2010 and 2011? Explain.
For each of the intended uses of the derivatives listed below, explain the accounting in fair value:
o Derivative designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability to or firm commitment
o Derivative designated as a hedge of the exposure to variable cash flows of a forecasted transaction
o Derivative designated as a hedge of the foreign currency exposure of a net investment in a foreign operation
Briefly discuss how the two basic require