On November 5, year 2, a Dunn Corp. truck was in an accident
with an auto driven by Bell. Dunn received notice on January
12, year 3, of a lawsuit for $700,000 damages for personal
injuries suffered by Bell. Dunn Corp.’s counsel believes it is
probable that Bell will be awarded an estimated amount in the
range between $200,000 and $450,000, and that $300,000 is a
better estimate of potential liability than any other amount.
Dunn’s accounting year ends on December 31, and the year 2
financial statements were issued on March 2, year 3. What
amount of loss should Dunn accrue at December 31, year 2?
(c) A loss contingency should be accrued if it is probable
that a liability has been incurred at the balance sheet date and
the amount of the loss is reasonably estimable. This loss must
be accrued because it meets both criteria. Notice that even
though the lawsuit was not initiated until 1/12/Y3, the liability
was incurred on 11/5/Y2 when the accident occurred. When
some amount within an estimated range is a better estimate than
any other amount in the range, that amount is accrued. Therefore,
a loss of $300,000 should be accrued. If no amount within
the range is a better estimate than any other amount, the amount
at the low end of the range is accrued and the amount at the high
end is disclosed.
During year 2, Haft Co. became involved in a tax dispute
with the IRS. At December 31, year 2, Haft’s tax advisor believed
that an unfavorable outcome was probable. A reasonable estimate
of additional taxes was $200,000 but could be as much as
$300,000. After the year 2 financial statements were issued, Haft
received and accepted an IRS settlement offer of $275,000. What
amount of accrued liability should Haft have reported in its December
31, year 2 balance sheet?
(a) The additional tax liability must be accrued as a loss
contingency because an unfavorable outcome is probable and
the amount of the loss is reasonably estimable. Since $200,000
is the reasonable estimate, that amount should be accrued by
debiting Income Tax Expense and crediting Income Tax Payable.
The possibility of the liability being as high as $300,000 would be
disclosed in the notes. The settlement offer of $275,000 is not
accrued at 12/31/Y2 because prior to financial statement issuance,
Haft was unaware of the offer, and $200,000 was the best
estimate. In year 3, when the settlement offer was accepted, Haft
would record an additional $75,000 of expense and liability.
Management can estimate the amount of loss that will occur
if a foreign government expropriates some company assets. If
expropriation is reasonably possible, a loss contingency should be
(a) A loss contingency is accrued if it is probable that a
liability has been incurred at the balance sheet date and the
amount of the loss is reasonably estimable. If no accrual is made
for a loss contingency because one or both of the conditions
above are not met, disclosure of the contingency shall be made
when it is at least reasonably possible that a loss was incurred.
Therefore, this loss should be disclosed, but not accrued as a liability.
Invern, Inc. has a self-insurance plan. Each year, retained
earnings is appropriated for contingencies in an amount equal to
insurance premiums saved less recognized losses from lawsuits
and other claims. As a result of a year 2 accident, Invern is a defendant
in a lawsuit in which it will probably have to pay damages
of $190,000. What are the effects of this lawsuit’s probable outcome
on Invern’s year 2 financial statements?
(b) Invern’s appropriation of retained earnings for
contingencies is merely a reclassification of retained earnings on
the balance sheet which tells the readers of the financial statements
that such amounts are generally not available to pay dividends.
This appropriation has no effect on the income statement.
When a loss contingency is probable (as in this instance)
and reasonably estimable ($190,000 in this instance), accrual of
the loss is required. Therefore, Invern must accrue both a liability
and an expense of $190,000. Note that Invern will also reclassify
$190,000 of appropriated retained earnings into the “general”
In year 1, a personal injury lawsuit was brought against Halsey
Co. Based on counsel’s estimate, Halsey reported a $50,000
liability in its December 31, year 1 balance sheet. In November
year 2, Halsey received a favorable judgment, requiring the
plaintiff to reimburse Halsey for expenses of $30,000. The plaintiff
has appealed the decision, and Halsey’s counsel is unable to
predict the outcome of the appeal. In its December 31, year 2
balance sheet, Halsey should report what amounts of asset and
liability related to these legal actions?
(d) At 12/31/Y2, Halsey’s contingent liability of
$50,000 is no longer probable due to the favorable judgment and
the inability to predict the outcome of the appeal. Therefore, no
liability should be reported in the balance sheet. Gain contingencies
are not reflected in the accounts until realized, so the
$30,000 asset is not reported in the 12/31/Y2 balance sheet,
During January year 2, Haze Corp. won a litigation award
for $15,000 that was tripled to $45,000 to include punitive damages.
The defendant, who is financially stable, has appealed only
the $30,000 punitive damages. Haze was awarded $50,000 in an
unrelated suit it filed, which is being appealed by the defendant.
Counsel is unable to estimate the outcome of these appeals. In
its year 2 financial statements, Haze should report what amount
of pretax gain?
(a) Gain contingencies are not recognized in the income
statement until realized. As only $15,000 of the litigation
awards has been resolved as of December 31, year 2, Haze should
report only $15,000 as a gain in its year 2 financial statements.
In May year 1 Caso Co. filed suit against Wayne, Inc. seeking
$1,900,000 damages for patent infringement. A court verdict
in November year 5 awarded Caso $1,500,000 in damages, but
Wayne’s appeal is not expected to be decided before year 7.
Caso’s counsel believes it is probable that Caso will be successful
against Wayne for an estimated amount in the range between
$800,000 and $1,100,000, with $1,000,000 considered the most
likely amount. What amount should Caso record as income from
the lawsuit in the year ended December 31, year 5?
(a) Gain contingencies are not reflected in the accounts
until realized. Since the case is unresolved at 12/31/Y5, none of
this contingent gain should be recorded as income in year 5.
Adequate disclosure should be made of the gain contingency, but
care should be taken to avoid misleading implications as to the
likelihood of realization.
During year 2, Smith Co. filed suit against West, Inc. seeking
damages for patent infringement. At December 31, year 2,
Smith’s legal counsel believed that it was probable that Smith
would be successful against West for an estimated amount in the
range of $75,000 to $150,000, with all amounts in the range considered
equally likely. In March year 3, Smith was awarded
$100,000 and received full payment thereof. In its year 2 financial
statements, issued in February year 3, how should this award
(d) Gain contingencies are not reflected in the accounts
until realized. Since the case was unresolved at 12/31/Y2, none
of this contingent gain can be recorded as a receivable and/or
revenue in year 2. Since the contingency is probable, it should be
disclosed along with the 12/31/Y2 estimate of a range of $75,000
to $150,000. A gain contingency would not be accrued as a receivable.
The amount disclosed should be the range because all
amounts within the range are considered equally likely.
In year 2, a contract dispute between Dollis Co. and Brooks
Co. was submitted to binding arbitration. In year 2, each party’s
attorney indicated privately that the probable award in Dollis’
favor could be reasonably estimated. In year 3, the arbitrator
decided in favor of Dollis. When should Dollis and Brooks recognize
their respective gain and loss?
Dollis’ gain Brooks’ loss
(c) An estimated loss from a loss contingency shall be
accrued by a charge to income if both of the following conditions
1. Information available indicates that it is probable that
an asset has been impaired or a liability has been incurred.
2. The amount of the loss can be reasonably estimated.
However, gain contingencies are only recognized when a specific
event actually occurs, not prior to the event, because to do so
would recognize the gain prior to its realization. Therefore,
Brooks should recognize the loss in year 2 due to the fact that the
event is probable and can be reasonably estimated. Dollis, on the
other hand, cannot recognize the gain until year 3, the year they
receive the actual award.
Eagle Co. has cosigned the mortgage note on the home of
its president, guaranteeing the indebtedness in the event that the
president should default. Eagle considers the likelihood of default
to be remote. How should the guarantee be treated in Eagle’s
(a) Eagle Co. has a contingent liability where the
possibility of loss is remote. Loss contingencies are accrued
when they are probable and reasonably estimable. All others
are disclosed unless remote. However, some contingencies, such
as guarantees of others’ debts, standby letters of credit by banks,
and agreements to repurchase receivables, are disclosed even if
remote. Eagle’s contingent liability is not accrued, because it is
not probable. It is disclosed for two reasons: it is a guarantee of
other’s debt, and it is a related-party transaction.