Question

During 2020, Bad Bunny, Inc. was sued by the EPA for leaving toxic waste on the land of its former headquarters. Bad Bunny’s attorneys have indicated that they believe it is very likely that Bad Bunny will lose this dispute. They also believe that Bad Bunny will have to pay the EPA between $5 million and $10 million. No particular amount in this range is considered more likely than any other. Bad Bunny has environmental insurance that may cover up to $5 million of this possible loss.

i. Briefly explain in complete sentences the relevant accounting issues and whether they should lead to recording of journal entries and recognition in the financial statements. If any footnote disclosure is needed, just summarize what should be disclosed, don’t write actual footnotes.

ii. Prepare any relevant journal entries as of 12/31/20, the company’s fiscal year-end date. If none are required, explain why.

iii. If anything needs to be reported on the 2020 income statement and balance sheet indicate what accounts and amounts will be reported. Make it clear what is on the income statement and what is on the balance sheet.

b) Total payroll of Walnut Co. on September 18, 2020, was $3,000,000, of which $400,000 represented amounts paid in excess of $130,000 to certain employees. The F.I.C.A. tax is 7.65% on an employee’s salaries and wages up to $130,000 and 1.45% in excess of $130,000. Federal income taxes withheld were $500,000, state income taxes withheld were $100,000, and voluntary employee contributions to retirement plans withheld were $150,000. Payment for all amounts will be made on September 25. Prepare the September 18 journal entry in proper form for the expenses and liabilities.

Answer 1

At the outset, it is to be noted that US GAAP requires any contingent liability--i. to be recorded , in books of accounts , if it is probable & amt . Estimable----ii. to be only disclosed as footnotes to accounts, if it is only probable & amt. not estimable--- & iii. ignored, if remote, ie. both occurrence & amt. not foreseeable.

i.Given that Bad Bunny’s attorneys have indicated that they believe it is very likely that Bad Bunny will lose this dispute---

ie. the liability is most probable , in future

& it is also stated in the question that

the attorneys believe that Bad Bunny will have to pay the EPA between $5 million and $10 million---& the loss can be any amount in this range , with equal probability (ie.meaning of "No particular amount in this range is considered more likely than any other")

In this context, it is to be noted that US GAAP insists, on recording such probable & estimable liabilities only,at the lowest end of the range--- in this case, the expected loss /expense towards compensation , $ 5 million

& that Bad Bunny has environmental insurance that may cover up to $5 million of this possible loss----

they need not record any probable(contingent) liability , in books of accounts, by way of accounting entries

But it is absolutely necessary that it is adequately   disclosed (with all facts & figures, along with insurance indemnity), as footnotes to the financial statements.

The disclosure will also take care , of the fact of informing all the users of the financial statements--- that there exists a possibility of the liability , exceeding the amount covered by insurance--aimed towards providing a true & fair presentation of the state of affairs of the company.

ii.On the lines of the above, NO JOURNAL ENTRY is required.

as the company already has an insurance policy--that will adequately take care of the lowest probable estimate, very likely to arise , in future.

iii.As no journal entry , need be passed, nothing will be reported on the 2020 income statement and balance sheet .

	b. Walnut Company
	Payroll journal entries
18-Sep	Salaries expense	3000000
	FICA taxes payable ((3000000-400000)*7.65%)+(3000000*1.45%)		242400
	Federal income taxes withheld		500000
	State income taxes withheld		100000
	Voluntary employee contributions to retirement plans withheld		150000
	Salaries payable		2007600
	Payroll tax expense	242400
	FICA taxes payable(employer)		242400
25-Sep	Salaries payable	2007600
	FICA taxes payable(242400+242400)	484800
	Federal income taxes withheld	500000
	State income taxes withheld	100000
	Voluntary employee contributions to retirement plans withheld	150000
	Cash		3242400