Question

Several years ago in its annual report, Philip Morris Companies, a major manufacturer of tobacco and food products, included footnote 16, which was almost five pages long. It consisted of a number of separate sec- tions covering such topics as an overview of tobacco-related litigation, the type and number of cases, pend- ing and upcoming trials, verdicts in individual cases, litigation settlements, smoking and health litigation, health care and cost-recovery litigation, and certain other tobacco-related litigation. During the year, over 500 smoking and health-related cases had been filed against the company, an increase of 30 percent over the previous year and 200 percent over the year before that. The company booked a pretax charge of over $3 billion, reducing reported net income to slightly over $5 billion. REQUIRED: Discuss Philip Morris's disclosure and accrual in terms of (1) the methods used to account for loss contingen- cies, and (2) the potential economic consequences associated with the disclosure and accounting treatment.

Answer 1

Loss contingency are expenses which are booked by an organization against any future possible events for eg future law suits which have an impact on organization's financial statements. They give an idea to the readers and users of financial statements regarding any future expenses which are likely to occur and which will be an obligation for the organization.

Such expenses should be booked by the company on an accrual basis to comply with accrual system of accounting in balance sheets and footnotes, if they are probable and their quantity can be reasonably estimated.

In the given case, Philip Morris company, a manufacturer of tobacco and food products have estimated their loss contingency for various law suits registered against company and have duly accounted them by booking a pre-tax charge of over $3 billion and this reducing their income to $5 billion. It has also included the same in its footnotes mentioning the various law suits as over 500 smoking and health related cases have been filed against it. The same is done to comply with accrual system of accounting and to follow conservatism principle of accounting. This company has rightly obligated it by

I) Charging the estimated amount as expenses in Income statement and

II) disclosing it in footnotes to accounts

This enables the users to financial statements to understand financial statements in a better way.

2) The potential economic consequences associated with disclosure and accounting treatment are that this may effect company's going concern Principle. This may also affect companies share price in the market. Also seeing this information potential investors of the company may be in doubt whether to invest or not. This will also have an impact on the overall profit of the company.