Question

Respond to the specific questions in each of the two cases, below.

Case A The following disclosure note appeared in the 31 December 20X5 financial statements of Dridell Corporation, a manufacturer of electronic equipment:

Dridell is exposed to liabilities and compliance costs arising from its past and current generation, management, and disposal of hazardous substances and wastes. As of 30 December 20X5, the accruals on the consolidated SFP for environmental matters were $20 million. Based on information available as of 31 December 20X5, management believes that the existing accruals are sufficient to satisfy probable and reasonably estimable environmental liabilities related to known environmental matters. Any additional liabilities that may result from these matters, and any additional liabilities that may result in connection with other locations currently under investigation, are not expected to have a material adverse effect on the business, results of operations, financial condition, and liquidity of Dridell. The company has a fund set up for all environmental matters.

Case B The following disclosure note is from the 31 December 20X2 financial statements of Zing Ltd., a property developer:

On 7 January 20X3, the Corporation contracted to acquire 60 residential housing units from a third party for a purchase price of $2.8 million, cash. On 24 January 20X3, the Company issued 240,000 stock options to senior officers of the company. These options have a three-year vesting period, with one-third vesting on each anniversary date.

 

Required:

For each of these two disclosure notes, explain:

1. What is the purpose of the note?

2. What types of management estimates are implied by this disclosure?

3. What implications might this note have for the financial reporting in future years, if any?

Answer 1

Case A

1.   The purpose is to alert financial statement readers to the approximate nature of a substantial constructive liability. The liability may turn out to be more or less than the currently-accrued amount, possibly quite substantially so.

2.   The estimates are:

• The extent of efforts that will be required to satisfactorily manage and correct environmental problems that arise from the company’s past operations.

• The cost of the corrective action.

• The timing of the corrective action (affects discounting of future liabilities).

• Implicitly, the extent and cost of any legal judgements brought against the company as the result of environmental degradation.

• The range of possible overall costs.

• The extent of the impact on future statements, including the future operating performance and continued financing of the company’s operations

An additional unstated assumption is that factors affecting these estimates (e.g., environmental legislation) will not change – a dubious assumption.

3.   Future years’ financial statements will be affected by continuing adjustments to the amount of the accrual, including accretions as the result of continuing operations.

 

Case B

1. This disclosure note informs the financial statement user of the presence of events that took place after the balance sheet date (subsequent events).

2. These events x purchase of a residential housing units and issuance of stock options x took place after the end of the past fiscal year, and will be recorded in the current (next) fiscal year. However, the financial statement user should be made aware of significant events that take place after the year-end, and this note serves that purpose.

3. When options are recorded next year, they are recorded at fair value and there will be a compensation expense recorded. If and when the options are exercised, the increase in the number of shares outstanding will dilute (i.e., decrease) the EPS. This happens because options are exercised only when the option price is well below market price of the shares, and thus the increased investment cannot earn the company sufficient return to prevent dilution.