Question

P10.8A (LO 2, 4) AP Mega Company, a public company, is preparing its financial statements for the year ended December 31, 2021. It is now January 31, 2022, and the following situations are being reviewed to determine the appropriate accounting treatment: Discuss reporting of contingencies and record provisions. 1. Mega Company is being sued for $4 million for a possible malfunction of one of its products. In July 2021, a customer suffered a serious injury while operating the product. The company is vigorously defending itself as it is clear the customer was intoxicated when using the product. 2. In a separate lawsuit, Mega is being sued for $3 million by an employee who was injured on the job in February 2021. It is likely that the company will lose this lawsuit, but a reasonable estimate cannot be made of the amount of the expected settlement. 3. On December 7, 2021, a potential customer injured himself when he slipped on the floor in the foyer of Mega Company's office building. Mega Company did not have appropriate floor mats in place and melting snow from the customer's boots made the floor very dangerous. Mega has negotiated a potential settlement of $200,000 with the individual's lawyer. Instructions For each of the above situations, recommend whether Mega Company should: (1) make an accrual in its December 31, 2021, financial statements; (2) disclose the situation in the notes to the financial statements; or (3) not report it. Provide a rationale for your recommendations. Taking It Further statements? What are the potential benefits and costs of making an accrual for a contingency as opposed to only disclosing it in the notes to the financial

Answer 1

Contingent liabilities need to be shown as an expense and corresponding liability recognised in case where it is possible to determine the amount of contingent liability and where the same is likely (probability greater than 50%) to be incurred.

Again the liabilities where the amount cannot be ascertained or the outcome of the liability cannot be estimated, the same may be reported in the notes to financial statements.

Again where the chances of liability

In case where the chances of the liability being incurred is less than 50% or remote, the same should not find a place in the balance sheet.

1. In this case Mega Company does not need to make any reporting in notes to financial statements or recognise any liability since the customer was intoxicated when using the product and there is reasonable chance that the Company will win the lawsuit. The Company is sure of the position in this case and is vigorously defending the same.

2. In this case the suit is filed for $3million and the company is expected to lose the lawsuit, however the settlement amount cannot be estimated. Hence this should find a place in the notes to financial statement as the amount of liability to be recognised cannot be determined.

3. The lawsuit filed here is supposedly to be won by the potential customer who was injured in the premises of the Mega Company. Again a potential settlement amount of $200,000 is being negotiated with the individual's lawyer. Hence the same needs to be recognised as a contingent liability.

Benefits of making an accrual for contingent liability v/s reporting in notes to financial statements - The financial statements would reflect the true picture, as the expense & liability would have been recorded.

Cost of making an accrual for contingent liability - The profits of the company would be hit immediately in the current year.