The nature of accounting liabilities
In some cases, it is not clear whether a company has an accounting liability and, if it has, how it should be measured. Consider the following (independent) situations.
(1) Self-insurance
A retail chain has traditionally purchased insurance cover from an insurance company to meet claims, by customers and staff, for personal injury in company stores. In view of the size of the annual premiums paid and the absence of claims in recent years, the company is considering insuring itself. The chief executive officer (CEO) has suggested the company set up a provision for injury claims along the following lines:
Dr. Insurance expense (OE-) xx
Cr. Provision for injury claims (L+) xx
When claims are submitted and accepted, the company would then charge the amount against the provision (Dr. Provision; Cr. Cash).
Required
The controller has doubts about whether the above accounting treatment is acceptable. Advise her.
(2) Post-employment compensation
The date is end-March x5. As a result of a boardroom clash, the board of directors of a pharmaceut- ical company dismissed the CEO earlier in the month. Under the terms of his contract, the ex-CEO is entitled to receive his annual salary of 900,000 until June x8. However, the contract also states that the payments may cease - at the company's option - if he accepts employment from another pharmaceutical company during this period. The ex-CEO is well-regarded in the industry. Under his leadership, the company's share price has doubled in the last three years.
The company's financial year runs to 30 June. Therefore, the total salary payments the ex-CEO might receive, subsequent to his dismissal, could be 3 million:
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Financial year x4/x5
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300,000
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(1/3 ´ 900,000)
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x5/x6
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900,000
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|
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x6/x7
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900,000
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|
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x7/x8
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900,000
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The controller believes the company has a liability and expense of 3 million in March x5. The board, however, would prefer not to record a liability of that amount then. They feel the company should recognise an expense (of 75,000) each month only when a salary payment is made.
Required
How should the company account for the ex-CEO's post-employment compensation?
(3) Lawsuit
In x2 a law firm launches legal action against Sonia, a manufacturer of mobile phones, seeking substantial damages on behalf of customers who, it's claimed, have developed brain tumours as a result of radiation emitted by the company's phones. Sonia contests the claim. Lawyers acting for the company advise management that, because scientists have not yet established a link between mobile phone use and incidence of brain tumours, the company will probably win the case.
Required
(a) How should Sonia report the lawsuit in its x2 accounts? (Assume the size of the plaintiffs' claim is material to its accounts.)
(b) Consider the following scenario. The year is x3 and the case is still in progress. Damaging new scientific evidence has emerged. Sonia's lawyers put the probability of the company winning the case at only 40%. They recommend the company seek an out-of-court settlement. However, management are fearful that a settlement could encourage a rash of lawsuits from other customers and this would have severe financial consequences for the firm and its shareholders. They decide to continue contesting the suit. How should Sonia report the lawsuit in its x3 accounts?