A gain contingency is an uncertain situation that might result in a gain. For example, in a pending lawsuit, one side—the defendant—faces a loss contingency; the other side—the plaintiff—has a gain contingency. As we discussed earlier, loss contingencies are accrued when the event confirming the obligation is probable and the amount can reasonably be estimated. However, gain contingencies are not accrued. The nonparallel treatment of gain contingencies follows the same conservative reasoning that motivates reporting some assets at lower of cost or market. Specifically, it's desirable to anticipate losses, but recognizing gains should await their realization.
| ||Gain contingencies are not accrued.|
Though gain contingencies are not recorded in the accounts, material ones are disclosed in notes to the financial statements. Care should be taken that the disclosure note not give “misleading implications as to the likelihood of realization.”31
Hanover Industries manufactures and sells food products and food processing machinery. While preparing the December 31, 2011, financial statements for Hanover, the following information was discovered relating to contingencies and possible adjustments to liabilities. Hanover's 2011 financial statements were issued on April 1, 2012.
On November 12, 2011, a former employee filed a lawsuit against Hanover alleging age discrimination and asking for damages of $750,000. At December 31, 2011, Hanover's attorney indicated that the likelihood of losing the lawsuit was possible but not probable. On March 5, 2012, Hanover agreed to pay the former employee $125,000 in return for withdrawing the lawsuit.
Hanover believes there is a possibility a service provider may claim that it has been undercharged for outsourcing a processing service based on verbal indications of the company's interpretation of a negotiated rate. The service provider has not yet made a claim for additional fees as of April 2012, but Hanover feels it will. Hanover's accountants and legal counsel believe the charges were appropriate but that if an assessment is made, there is a reasonable possibility that subsequent court action would result in an additional tax liability of $55,000.
Hanover grants a one-year warranty for each processing machine sold. Past experience indicates that the costs of satisfying warranties are approximately 2% of sales. During 2011, sales of processing machines totaled $21,300,000. 2011 expenditures for warranty repair costs were $178,000 related to 2011 sales and $220,000 related to 2010 sales. The January 1, 2011, balance of the warranty liability account was $250,000.
Hanover is the plaintiff in a $600,000 lawsuit filed in 2010 against Ansdale Farms for failing to deliver on contracts for produce. The suit is in final appeal. Legal counsel advises that it is probable that Hanover will prevail and will be awarded $300,000 (considered a material amount).
Included with certain food items sold in 2011 were coupons redeemable for a kitchen appliance at the rate of five coupons per appliance. During 2011, 30,000 coupons were issued and 5,000 coupons were redeemed. Although this is the first such promotion in years, past experience indicates that 60% of coupons are never redeemed. An inventory of kitchen appliances is maintained, and a count shows that 1,000 are on hand at December 31, 2011, with a normal retail value of $20,000 and a cost to Hanover of $8,000.
Determine the appropriate reporting for each situation. Briefly explain your reasoning.
Prepare any necessary journal entries and state whether a disclosure note is needed.
This is a loss contingency. Hanover can use the information occurring after the end of the year in determining appropriate disclosure. The cause for the suit existed at the end of the year. Hanover should accrue the $125,000 loss because an agreement has been reached confirming the loss and the amount is known.
A disclosure note also is appropriate.
| Liability—litigation ................................|
At the time financial statements are issued, a claim is as yet unasserted. However, an assessment is probable. Thus, (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated are considered. No accrual is necessary because an unfavorable outcome is not probable. But because an unfavorable outcome is reasonably possible, a disclosure note is appropriate.
Note: If the likelihood of a claim being asserted is not probable, disclosure is not required even if an unfavorable outcome is thought to be probable in the event of an assessment and the amount is estimable.
The contingency for warranties should be accrued because it is probable that expenditures will be made and the amount can be estimated from past experience. When customer claims are made and costs are incurred to satisfy those claims the liability is reduced.
The liability at December 31, 2011, would be reported as $278,000:
|Warranty expense (2% × $21,300,000) ........................................|
| Estimated warranty liability ..........................................................|
|Estimated warranty liability ($178,000 + 220,000) .........................|
| Cash, wages payable, parts and supplies, etc. ............................|
A disclosure note also is appropriate.
This is a gain contingency. Gain contingencies cannot be accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. It can be disclosed, but care should be taken to avoid misleading language regarding the realizability of the gain.
The contingency for premiums should be accrued because it is probable that coupons will be redeemed and the amount can be estimated from past experience. When coupons are redeemed and appliances are issued, the liability is reduced.
The liability at December 31, 2011, would be reported as $11,200:
|Promotional expense (40% × [30,000 ÷ 5] × $8*) ............................|
| Estimated premium liability ..............................................................|
|Estimated premium liability ([5,000 ÷ 5] × $8*) ................................|
| Inventory of premiums ..................................................................|
|DECISION MAKERS' PERSPECTIVE|
| Current liabilities impact a company's liquidity. Liquidity refers to a company's cash position and overall ability to obtain cash in the normal course of business. A company is said to be liquid if it has sufficient cash (or other assets convertible to cash in a relatively short time) to pay currently maturing debts. Because the lack of liquidity can cause the demise of an otherwise healthy company, it is critical that managers as well as outside investors and creditors maintain close scrutiny of this aspect of a company's well-being.
|| || (K)|
Keeping track of the current ratio is one of the most common ways of doing this. The current ratio is intended as a measure of short-term solvency and is determined by dividing current assets by current liabilities.
| ||A risk analyst should be concerned with a company’s ability to meet its short-term obligations.|
When we compare liabilities that must be satisfied in the near term with assets that either are cash or will be converted to cash in the near term, we get a useful measure of a company's liquidity. A ratio of 1 to 1 or higher often is considered a rule-of-thumb standard, but like other ratios, acceptability should be evaluated in the context of the industry in which the company operates and other specific circumstances. Keep in mind, though, that industry averages are only one indication of adequacy and that the current ratio is but one indication of liquidity.
We can adjust for the implicit assumption of the current ratio that all current assets are equally liquid. The acid-test, or quick, ratio is similar to the current ratio but is based on a more conservative measure of assets available to pay current liabilities. Specifically, the numerator, quick assets, includes only cash and cash equivalents, short-term investments, and accounts receivable. By eliminating current assets such as inventories and prepaid expenses that are less readily convertible into cash, the acid-test ratio provides a more rigorous indication of a company's short-term solvency than does the current ratio.
| ||A manager should actively monitor a company’s liquidity.|
If either of these liquidity ratios is less than that of the industry as a whole, does that mean that liquidity is a problem? Perhaps. It does, though, raise a red flag that suggests caution when assessing other areas. It's important to remember that each ratio is but one piece of the puzzle. For example, profitability is probably the best long-run indication of liquidity. Also, management may be very efficient in managing current assets so that some current assets—receivables or inventory—are converted to cash more quickly than they otherwise would be and are more readily available to satisfy liabilities. The turnover ratios discussed in earlier chapters help measure the efficiency of asset management in this regard.
| ||A liquidity ratio is but one indication of a company’s liquidity.|
In fact, some companies view their accounts payable as a free loan from their suppliers, just as they view their accounts receivable as a free loan to their customers. These companies tend to pressure their customers to pay quickly, but try to obtain more extended terms with their suppliers. Although this would produce relatively low current assets and high current liabilities, and therefore a lower current ratio, it could be a very intelligent way to manage cash and decrease the overall amount of capital needed by the company to finance operations.
| ||Some companies maintain relatively high current liabilities as part of a cashmanagement strategy|
Given the actual and perceived importance of a company's liquidity in the minds of analysts, it's not difficult to adopt a management perspective and imagine efforts to manipulate the ratios that measure liquidity. For instance, a company might use its economic muscle or persuasive powers to influence the timing of accounts payable recognition by asking suppliers to change their delivery schedules. Because accounts payable is included in the denominator in most measures of liquidity, such as the current ratio, the timing of their recognition could mean the difference between an unacceptable ratio and an acceptable one, or between violating a debt covenant and compliance. For example, suppose a company with a current ratio of 1.25 (current assets of $5 million and current liabilities of $4 million) is in violation of a debt covenant requiring a minimum current ratio of 1.3. By delaying the delivery of $1 million of inventory, the ratio would be 1.33 (current assets of $4 million and current liability of $3 million).
| ||Analysts should be alert for efforts to manipulate measures of liquidity.|
It is important for creditors and analysts to be attentive for evidence of activities that would indicate timing strategies, such as unusual variations in accounts payable levels. You might notice that such timing strategies are similar to earnings management techniques we discussed previously—specifically, manipulating the timing of revenue and expense recognition in order to “smooth” income over time.
Finally, all financial statement users need to keep in mind the relation between the recognition of unearned revenue associated with advance payments and the later recognition of revenue. On the one hand, increases in unearned revenue can signal future revenue recognition because the unearned revenue likely will eventually be recognized as revenue. On the other hand, research suggests that some firms that report unearned revenue may manipulate the timing of revenue recognition to manage their earnings.32
| ||Changes in unearned revenue provide information about future revenue, and may be used to manipulate it.|
In the next chapter, we continue our discussion of liabilities. Our focus will shift from current liabilities to long-term liabilities in the form of bonds and long-term notes.
|FINANCIAL REPORTING CASE SOLUTION|
What are accrued liabilities? What is commercial paper?(p. 697) Accrued liabilities are reported for expenses already incurred but not yet paid (accrued expenses). These include salaries and wages payable, income taxes payable, and interest payable. Commercial paper is a form of notes payable sometimes used by large corporations to obtain temporary financing. It is sold to other companies as a short-term investment. It represents unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 30 to 270 days. Typically, commercial paper is issued directly to the buyer (lender) and is backed by a line of credit with a bank.
Why did Syntel Microsystems include some long-term debt in the current liability section?(p. 702) Syntel Microsystems did include some long-term debt in the current liability section. The currently maturing portion of a long-term debt must be reported as a current liability. Amounts are reclassified and reported as current liabilities when they become payable within the upcoming year.
Did they also report some current amounts as long-term debt? Explain.(p. 703) Yes they did. It is permissible to report short-term obligations as noncurrent liabilities if the company (a) intends to refinance on a long-term basis and (b) demonstrates the ability to do so by a refinancing agreement or by actual financing. As the disclosure note explains, this is the case for a portion of Syntel's currently payable debt.
Must obligations be known contractual debts in order to be reported as liabilities?(p. 706) No. From an accounting perspective, it is not necessary that obligations be known, legally enforceable debts to be reported as liabilities. They must only be probable and the dollar amount reasonably estimable.
| |Is it true that current liabilities are riskier than long-term liabilities?(p. 719)
Other things being equal, current liabilities generally are considered riskier than longterm liabilities. For that reason, management usually would rather report a debt as long term. Current debt, though, is not necessarily risky. The liquidity ratios we discussed in the chapter attempt to measure liquidity. Remember, any such measure must be assessed in the context of other factors: industry standards, profitability, turnover ratios, and risk management activities, to name a few. (0.0K)
31FASB ASC 450–30–50: Contingencies–Gain Contingencies–Disclosure (previously “Accounting For Contingencies,” Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 17).
*$8,000 ÷ 1,000 = $8
32Yuan Zhang, “An Empirical Analysis of Revenue Manipulation,” Columbia Business School working paper, April 12, 2006.