Question

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E13.13B (L0 3) (Contingencies) Presented below are three independent situations. Answer the question at the end of each situation.

1. During 2020, Santiago Inc. became involved in a tax dispute with the IRS. Santiago’s attorneys have indicated that they believe it is probable that Santiago will lose this dispute. They also believe that Santiago will have to pay the IRS between $225,000 and $350,000. After the 2020 financial statements were issued, the case was settled with the IRS for $300,000. What amount, if any, should be reported as a liability for this contingency as of December 31, 2020?
2. On October 1, 2020, Washington Chemical was identified as a potentially responsible party by the Environmental Protection Agency. Washington Chemical’s management and its counsel have concluded that it is probable that Washington will be responsible for damages, and a reasonable estimate of these damages is $1,250,000. Washington Chemical’s insurance policy of $2,250,000 has a deductible clause of $125,000. How should Washington Chemical report this information in its financial statements at December 31, 2020?
3. Sandberg Inc. had a manufacturing plant in Bosnia, which was destroyed in the civil war there. It is not certain who will compensate Sandberg for this destruction, but Sandberg 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 Sandberg Inc.?

Answer 1

Part 1

Santiago Inc. would report a liability of $225000

According to the FASB, when the range of expected loss is provided, then the amount that appears to be a better estimate is considered to be accrued. In case of no such better estimated, the lowest amount in the range is considered to be accrued. In the given case the loss is probable, however range is possible to be estimated, and therefore loss and contingent liability can be accrued. As no particular estimate within the range can be reasonably estimated, Santiago Inc. would report a liability of $225,000 at December 31, 2020.

Part 2

Washington Chemical should accrue the loss (deductible amount) of $125,000

Insurance company is responsible for the liability amounts that exceed the deductible. However, the potential insurance recovery is treated as a gain contingency and thus it is not recorded until it is received.

Part 3

No amount for the contingency should be reported in the financial statements of Sandberg Inc.

The amount to be received will be greater than the book value of the plant, thus there will be a gain contingency.

Instead of recording, the gain contingencies are disclosed and that also only during the times when the probabilities of a gain contingency becoming a reality is very high.