Question

Latinum Star Corporation (Latinum), a publicly traded company with a December 31 year-end,

conducts business activities primarily related to the design, development, manufacture, and

assembly of passenger cars, recreational and sport-utility vehicles, minivans, and trucks. In the

design of Latinum’s iconic Brice sports car line, the company used asbestos in the manufacturing

of brake shoes and gaskets because of its heat resistance. As described below, two class-action

lawsuits have been filed against Latinum - one in 2016, and the other in 2017 - by automotive

mechanics or their surviving family members seeking recovery because of the mechanics’

alleged exposure to asbestos from Latinum’s Brice automobile parts.

In November 2016, Latinum was served a complaint in the U.S. District Court alleging that 50

automotive mechanics suffered severe illnesses that led to death as a result of exposure to

asbestos from parts manufactured by Latinum. The case was brought against Latinum by

surviving family members as a class-action lawsuit seeking damages totaling approximately

$100 million. Latinum did not believe the asbestos used in the manufacturing of the Brice brake

shoes and gaskets caused the mechanics’ deaths and immediately retained external legal counsel

to vigorously defend the claim made against Latinum in this complaint. Since this legal matter

was in its early stages of discovery, Latinum determined that (1) the risk of potential loss at that

time was remote and (2) no amount of potential damages could be reasonably estimated.

Therefore, Latinum made no disclosure of the legal matter in its SEC Form 10-K for the year

ended December 31, 2016.

In October 2017, Latinum was served a second complaint alleging that an additional 100

mechanics suffered severe illnesses that led to disability because of exposure to asbestos from

Latinum’s Brice automobile parts. This matter was also filed as a class-action lawsuit and seeks

damages from Latinum totaling approximately $250 million.

The first class-action lawsuit remained in the discovery phase for almost the entire year of 2017.

In December 2017, evidence was discovered by Latinum’s external counsel relating to both of

the lawsuits that led counsel to believe that Latinum could potentially, but not probably, be liable

for a percentage of the recovery sought by the claimants in each of those matters. Although

external counsel could not estimate the exact percentage of Latinum’s potential exposure,

counsel believed, on the basis of historical precedence, that the amount of potential loss was less

than 50 percent of the amount claimed.

Historical precedence exists from two similar asbestos class-action lawsuits against other

automotive manufacturers that were litigated within the past five years. One of the lawsuits

resulted in a verdict in court in favor of the mechanics and their surviving family members. This

lawsuit resulted in the defendant automotive manufacturer remitting payments to the plaintiffs

equal to 70 percent of the amount claimed. The other lawsuit was dismissed in court with

judgment in favor of the automotive manufacturer. In that second case, the automotive

manufacturer made no claim payments to the plaintiffs. The plaintiffs appealed the court’s final

decision, but the court denied the plaintiffs’ appeal.

After further assessment of the evidence discovered in the two lawsuits against Latinum, as of

December 31, 2017, Latinum’s General Counsel did not believe that it was probable that a loss

would occur and could not reasonably estimate an exact amount of the risk of potential loss as a

result of the two lawsuits.

(You may assume that no significant developments will occur in the discovery phase related to

the two lawsuits during the three-month period ended March 31, 2018).

Assume you are an in-house (internal) staff accountant at Latinum. Tess La, who recently joined

Latinum as its Chief Financial Officer (CFO), has asked you to research and recommend the

appropriate accounting treatment of the lawsuits filed against Latinum for the year ended

December 31, 2017. Using the codification as resource

Answer 1

Answer:

Standards:

As per Accounting standards (Source: FASB: Financial Accounting Standards): An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.

b. The amount of loss can be reasonably estimated.

If no accrual is made for a loss contingency because one or both of the conditions are not met, or if an exposure to loss exists in excess of the amount accrued, disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred.

Facts of the Case:

In case of Latinum Star Corporation (Latinum), based on assessment of the evidence discovered in the two lawsuits against Latinum, as of December 31, 2017, Latinum’s General Counsel did not believe that it was probable that a loss would occur and could not reasonably estimate an exact amount of the risk of potential loss as a result of the two lawsuits.

As advised in the question, it is assumed that no significant developments will occur in the discovery phase related to the two lawsuits during the three-month period ended March 31, 2018.

Based on opinion of General Counsel, the facts do not meet the conditions; as such no liability should be accrued. But the exposure must be disclosed.