Shares of Checkpoint Systems, which makes electronic anti-theft tags used by retailers, have dropped from 18 in April to 12.50 lately, in part because of an unseasonably warm winter, which dampened apparel sales. But don't expect the stock to re- bound soon, say some pros: The stock may well keep tumbling because of an antitrust lawsuit that Checkpoint lost.... In late May, a U.S. District Court in Pennsylvania assessed damages of \($26\) million.... The verdict could put Check- point in violation of bank covenants on 1999 bank loans. Even if Checkpoint appeals and puts off paying damages, accountants may require it to acknowledge the potential dam- ages in its financial statement. Therein lies the problem: It had borrowed \($273.9\) million from banks. Those loans have covenants that might be violated by putting new debt on its balance sheet. The covenants also require Checkpoint to have a net worth of \($200\) million. Its current net worth is \($240\) million, and the damages it will have to pay will bring it below required levels. 17.7007 Required:

1. When must firms record contingent liabilities on their balance sheets?

2. How does the district court decision influence whether Checkpoint's litigation contingency must be recorded?

3. Explain how recognition of the contingent liability will cause Checkpoint to violate its net worth covenant.

4. Is it likely that the banks will just waive the covenant violation if it occurs?