Question

1. In concept the SFAC definition is clear that for an obligation to meet the definition of a liability the entity must be required to deliver an asset of the obligated entity or provide a service. These cases ask you to analyze the concept that to meet the definition of a liability an entity must be obligated to deliver its own asset or perform services. In this analysis, you are asked to ignore current guidance, as the concept is not always applied.

Case 2

Prosperous has a bonus plan; payment of the bonus is contingent on the achievement of defined targets. At December 31, the company year end, an employee has qualified for a $200,000 bonus that will be paid on January 31, whether the employee is still employed. Consider these alternatives:

1. The bonus will be paid in shares of Prosperous with fair value equal to $200,000 at the payment date January 31. Is there a liability at year end? If so, why? If not, how would you account for this transaction (think about the journal entry)?

2. The bonus will be paid in 10,000 shares of Prosperous common stock at some point in the next fiscal quarter (meaning the employee could end up with more or less than a $200,000 bonus, depending on whether the stock appreciates or depreciates before payment of the bonus). At December 31, each share of Prosperous traded at $20 per share. Is there a liability at year end? What happens if the share price changes in the next quarter (before payment)?

3. The bonus amount of $200,000 is determined based on the changes in fair value of Prosperous common stock by applying the following formula: the employee will receive $20,000 cash bonus for every $1 increase in Prosperous share price, starting from the specified date and ending December 31. The fair value of the stock increased from $10 per share at the specified date to $20 per share on December 31. Is there a liability on December 31 if the bonus is to be paid in cash?

4. Would your answer to the previous question change if the $200,000 was paid in common shares and not cash? If so, how?

Answer 1

Answer.

The Bonus plan is contingent to the achievement of defined targets, thus using the matching principle, there is a need to recognize the bonus/expense the same period targets/revenues were met. In order for a liability to be recognized the standards define two basic criteria:

a. There is a probability that an future outflow of economic benefits will arose from the accounting events.

b. It should be estimated reliably.

Scenario 1.

Yes there is, it complies with letters A & B criteria, there is qualification for the bonus and the amount can be estimated reliably at $200,000 payment date.

Scenario 2.

There is no liability at December 31, Instead, we should disclose the possibility of an outflow in the Notes to Financial Statements only. The reason is because there is uncertain in the timing of the liability ("at some point in the next fiscal quarter").

Scenario 3.

There is a liability. It complies with letters A & B criteria, the amount can be estimated reliably thru the given formula of $20,000 cash bonus per $1 increase of the prosperous share. In this scenario total liability to be recognized in the books amounts to $200,000 (($20 - $10) X $20,000).

Scenario 4.

There is none. Scenario no. 3 does not indicate number of shares to be distributed as bonus. Please take note that a share of stock is indivisible and that it cannot be broken into smaller units unless otherwise the $200,000 can be exactly divided into no. of shares at the payment date or the formula/bonus scheme permitted to round off to the nearest whole number.