Question

Problem 13-6 Various contingencies [LO13-5, 13-6]

Eastern Manufacturing is involved with several situations that possibly involve contingencies. Each is described below. Eastern’s fiscal year ends December 31, and the 2018 financial statements are issued on March 15, 2019.

Eastern is involved in a lawsuit resulting from a dispute with a supplier. On February 3, 2019, judgment was rendered against Eastern in the amount of $116 million plus interest, a total of $131 million. Eastern plans to appeal the judgment and is unable to predict its outcome though it is not expected to have a material adverse effect on the company. In November 2017, the State of Nevada filed suit against Eastern, seeking civil penalties and injunctive relief for violations of environmental laws regulating hazardous waste. On January 12, 2019, Eastern reached a settlement with state authorities. Based upon discussions with legal counsel, the Company feels it is probable that $149 million will be required to cover the cost of violations. Eastern believes that the ultimate settlement of this claim will not have a material adverse effect on the company. Eastern is the plaintiff in a $209 million lawsuit filed against United Steel for damages due to lost profits from rejected contracts and for unpaid receivables. The case is in final appeal and legal counsel advises that it is probable that Eastern will prevail and be awarded $150 million. At March 15, 2019, Eastern knows a competitor has threatened litigation due to patent infringement. The competitor has not yet filed a lawsuit. Management believes a lawsuit is reasonably possible, and if a lawsuit is filed, management believes damages of up to $42 million are reasonably possible.

Required: 1. Determine the appropriate means of reporting each situation. 2. Prepare the appropriate journal entries for these situations.

Answer 1

Situation 1: Eastern is involved in a lawsuit resulting from a dispute with a supplier. On February 3, 2019, judgment was rendered against Eastern in the amount of $116 million plus interest, a total of $131 million. Eastern plans to appeal the judgment and is unable to predict its outcome though it is not expected to have a material adverse effect on the company.

Solution: This represents a loss contingency. Based on the information, Eastern is unable to predict the outcome of the appeal. In addition, the outcome is not expected to have a material adverse effect on the company. Therefore, Eastern would not record the $131 million loss. It would however, provide a disclosure note as below:

Note: Contingency In a lawsuit resulting from a dispute with a supplier, a judgement was rendered against company in the amount of $ 116 million plus interest, total of $131 million at February 3, 2019.Company plans to appeal the judgement. While management and legal counsel are presently unable to predict the outcome or to estimate the amount of any liability the company may have with respect to this lawsuit, it is not expected that this matter will have a material adverse effect on the company

Situation 2: In November 2017, the State of Nevada filed suit against Eastern, seeking civil penalties and injunctive relief for violations of environmental laws regulating hazardous waste. On January 12, 2019, Eastern reached a settlement with state authorities. Based upon discussions with legal counsel, the Company feels that it is probable that $149 million will be required to cover the cost of violations. Eastern believes that the ultimate settlement of this claim will not have a material adverse effect on the company.

This is a loss contingency. Because it is probable that Eastern will have to pay $149 million, which can be reasonably estimated, Eastern should record the loss and related liability, and provide footnote disclosure that details the nature of the litigation and the loss.

Loss –Litigation …………………………..149,000,000    

  Liability-Litigation……………..……….149,000,000

Notes: Litigation In November 2017, the State of Nevada filed suit against Company, seeking civil penalties and injunctive relief for violations of environmental laws regulating hazardous waste. On January 12, 2019, company announced that it had a settlement with state authorities on this matter. Based upon discussions with legal counsel, the Company has accrued and charged to operations $149 million to cover the anticipated cost of all violations. Company believes that the ultimate settlement of this claim will not have a material adverse effect on the company’s financial position.

Situation 3: Eastern is the plaintiff in a $209 million lawsuit filed against United Steel for damages due to lost profits from rejected contracts and for unpaid receivables. The case is in final appeal and legal counsel advises that it is probable that Eastern will prevail and be awarded $150 million.

Solution: This is a gain contingency. Even though the gain is probable and can be reasonably estimated, gain contingencies are not accrued. Rather any gain would be recognized with realized. Even though the gain contingency is not recognized, it should still be disclosed in a footnote. The actual disclosure would basically say the same thing as is included in the situation 3.

Note: Contingency Company is the plaintiff in a pending lawsuit against United steel for damages due to lost profits from rejected contracts and for unpaid receivables. The case is in final appeal. No amount has been accrued in the financial statements for possible collection of any claims in this litigation.

Situation 4: At March 15, 2019, Eastern knows a competitor has threatened litigation due to patent infringement. The competitor has not yet filed a lawsuit. Management believes a lawsuit is reasonably possible, and if a lawsuit is filed, management believes damages of up to $42 million are reasonably possible.

Solution: There would be no disclosure in this case because the competitor has not yet proposed a penalty assessment and the assessment is not probable. Even if an unfavourable outcome is thought to be probable in the event of an assessment and the amount is estimable, disclosure is not required unless an unasserted claim is probable.