Consider the following three scenarios involving publicly owned companies in the United States.
• One of the four wholly owned subsidiaries of Option Plastics, Inc., is located in a small South American country. Recent elections in the country have brought to power a political party that intends to nationalize all major businesses. The new president has indicated that the government will pay a ‘‘reasonable price’’ for these businesses. The manager of the South American subsidiary estimates that Option Plastics will suffer a loss of between $4 million and $6 million when the government buys out the subsidiary sometime in the next two years.
• Charles Iron works has just been slapped with a $ 5.5 million fine by the Environmental Protection Agency (EPA). The company’s legal counsel intends to contest the fine. When asked to evaluate the likelihood of overturning the EPA fine, the company’s chief legal counsel responded, ‘‘I think there’s a 50-50 chance that we can get the fine reduced. But
I have no idea if we can reduce the fine by $2 or by $2 million.’’
• Joy’s Toys manufactures a wide range of toys designed for children one to four years of age. This past week, a competitor, Gaver Corporation, sued Joy’s Toys for $17.2 million. The suit alleges that Joy’s Toys infringed on a patent that Gaver holds on a popular toy. In a press release, the chief executive of Joy’s Toys observed, ‘‘this suit is complete non sense. Gaver knows that we haven’t infringed on its patent. All this company is trying to do is harass us and damage our reputation.’’
Required:
(a) Evaluate each of the three scenarios in reference to the accounting and financial reporting guide-lines for contingent liabilities. How would you recommend that these items be accounted for and/or reported in each firm’s financial statements? Support your recommendation for each scenario.
(b) Do companies have an incentive to intentionally downplay the significance of contingent liabilities and thus exclude them from their financial statements? Explain. If such an exclusion occurs, how are decision makers who rely on financial statement data affected?