The items 1 through 6 below represent various commitments and contingencies of M

Question

The items 1 through 6 below represent various commitments and contingencies of Martin Inc. at December 31, 2011 and events subsequent to December 31, 2011, but prior to the issuance of the 2011 financial statements. Martin Inc. is preparing its financial statements for the year ended December 31, 2011.


1. On December 1, 2011, Martin was awarded damages of $75,000 in a patent infringement suit it brought against a competitor. The defendant did not appeal the verdict, and payment was received in January 2012.
2. A former employee of Martin has brought a wrongful-dismissal suit against Martin. Martin’s lawyers believe the suit to be without merit.
3. At December 31, 2011 Martin had outstanding purchase orders in the ordinary course of business for purchase of a raw material to be used in its manufacturing process. The market price is currently higher than the purchase price and is not anticipated to change within the next year.
4. A government contract completed during 2011 is subject to renegotiation. Although Martin estimates that it is reasonably possible that a refund of approximately $200,000-$300,000 may be required by the government, it does not wish to publicize this possibility.
5. Martin has been notified by a governmental agency that it will be held responsible for the cleanup of toxic materials at site where Martin formerly conducted operations. Martin estimates that it is probable that its share of remedial action will be approximately $500,000.
6. On January 5, 2012, Martin redeemed its outstanding bonds and issued new bonds with a lower rate of interest. The reacquisition price was in excess of the carrying amount of the bonds.

You have been asked by Martin Inc. to advice on the treatment of the above items for financial accounting and reporting purpose. Prepare a detailed report discussing the relevant FASB codifications how the above six items should be accrued, accrued and disclosed, disclosed only Or should neither be accrued nor disclosed.

Explanation / Answer

D. Disclosure only A. Accrual only B. Both accrual and disclosure N. Neither accrual nor disclosure 1. (B) Contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization. Since this gain contingency was resolved before the issuance of the financial statements, it is handled similar to an ordinary transaction that occurred prior to the year-end and is accrued in the year of its occurrence. However, disclosure of the contingencies that might result in gains is made in the notes to financial statements. 2. (N) To accrue an estimated loss from a loss contingency it is necessary that it is probable that an asset has been impaired or a liability has been incurred and that the amount of loss can be reasonably estimated. Since Lorn’s lawyers believe the suit to be without merit, neither condition has been met. Disclosure is also required of some loss contingencies that do not meet the accrual requirements if there is a reasonable possibility that a loss may be incurred. Again, this condition has not been met. 3. (N) The conditions described in this question would be considered general or unspecified business risks that do not meet the conditions for accrual or disclosure. 4. (D) The words “reasonably possible” require the disclosure of this item. No accrual need be made since the question does not state it is probable that an asset has been impaired or a liability incurred and that the amount of loss can be reasonably estimated. 5. (B) The word “probable” and the inclusion of the estimated amount of $500,000 mean that this situation meets the criteria of (1) a probable incurrence of a liability and (2) a reasonable estimate of an amount. 6. (D) Disclosure is made for commitments such as an obligation to reduce debts. Since the entire transaction took place in the next accounting period it does not meet the conditions for an accrual in the current period even though it would be disclosed in a footnote.

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