Question

a) List the three categories of contingent liabilities. Also, what does the company have to disclose or record for each category?

b) When issuing bonds, if the market interest rate is greater than the stated interest rate, will the bonds issue at a premium or a discount and why? Explain your reasoning for your answer.

Answer 1

a.List the three categories of contingent liabilities. Also, what does the company have to disclose or record for each category?

A contingent liability is either a possible obligation arising from past events and depending on future events not under an entity's control, or a present obligation not recognized because either the entity cannot measure the obligation or settlement is not probable. You do not recognize a contingent liability. Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote.

There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions.i.e when to record and when to disclose and when to no treatment . They are:

Recording . Record a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.

Disclosure. Disclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.

No treatment. Do not record or disclose a contingent liability if the probability of its occurrence is remote.

Examples of contingent liabilities are:

The outcome of a lawsuit-may be infringement of copyright, patents etc

A government investigation-May be result in an unforeseen action

The threat of expropriation

Threat of withdrawing high value license without any compensated payment

b. when issuing bonds, if the market interest rate is greater than the stated interest rate, will the bonds issue at a premium or a discount and why? Explain your reasoning for your answer.

Ans: The bond price and Interest rate have always an Inverse relationship, If Interest rate of the bond is less than the market interest rate then we have to issue for discount in order the protect the investor we should able to provide the same level of revenues either directly or indirectly , i.e either through interest or reducing the face value of price(for discount price). So that Investors can retains otherwise no one hold the bond which result in market value of the bond is full decreased or collapse.

In order to hold Market price stable and hold or regenerate or retain the investor, we should take an appropriate action by way of increase interest or provide at discount in order to achieve same level of earnings

For Example, If the investor invested 10000$ at the rate of 7% ($700)and if the market rate of interest is 8%($800) then investor no more to hold the bonds of low earnings or no further investment in the bonds He/she defiantly move to good earning source which will result in value may decreased and may be at the risk to the bond issuer,

in order to hold or retain we need to provide at discount which is equal to or more than market value of the earnings.