Discussion Problem- Contingent Liabilities

Overview - Contingent losses arising from litigation can be especially difficult to know how to report in the financial statements. Companies don't want to admit to the loss as it might hurt their case in court, but they can't mislead the users of their financial statements either by ignoring what could be a significant financial impact.

Instructions - You are the Chief Financial Officer of a firm that is being sued for damages it caused. It is the end of your fiscal year, and you are trying to determine the appropriate treatment of this matter. Your boss, the Chief Executive Officer acknowledges (privately) that your firm is responsible for the damages and that the judgement will be made against your firm. Your legal counsel estimates that the penalty levied by the court will be in the range of $2 million to $6 million, with a most likely amount of $4 million. The CEO's posture on the matter is that because of the wide variance in the range of possible outcomes (i.e. penalties levied) that the best thing to do is to simply wait until the case is settled (next year), and record at that time the actual damages assessed by the court.

Answer the following questions:

1. What are some possible reasons that the CEO may hold his viewpoint?

2. What should be your response to the CEO?

3. Do you think it is necessary to make an accrual for an estimated amount of the assessment or settlement? If so, what amount do you think is appropriate? Explain.

4. Would your answer to any of the above questions be different if the financials are being prepared under IFRS instead of U.S. GAAP?