California Turbo

California Turbo Corp. (CTC) manufactures exhaust systems that automakers use in the production of new vehicles. Competition in this market has waned in recent years. Many competitors exited the business in the economic downturn and few have returned because of the capital-intensive nature of the manufacturing process.

In 20X1, the Department of Justice (DOJ) launched an investigation involving CTC and two additional auto parts suppliers, alleging anticompetitive behavior involving price collusion between suppliers. Shortly after the DOJ investigation commenced, a number of customers formed a class-action lawsuit against the three suppliers, alleging that the suppliers fixed prices and overcharged customers as a result of these anticompetitive behaviors. Five entities opted out of the class-action lawsuit and separately undertook legal action against the individual suppliers, including CTC. These entities are existing customers of CTC.

In 20X2, CTC reached a settlement (the First Settlement) with three of the five entities that opted out of the class action lawsuit (the Plaintiffs). The terms of the First Settlement provide that CTC will pay the three Plaintiffs payments of:

$20 million consisting of $10 million due in 20X3 and $10 million due in 20X4. The $20 million is approximately equal to the amount that CTC overcharged the three Plaintiffs as a result of CTCs anticompetitive behavior. Call this the Overcharge Payment.

$10 million structured in the form of a volume incentive payment whereby the three

Plaintiffs, as a group, will receive a 5 percent rebate on their purchases during

20X3 in an amount not to exceed $10 million. This payment is intended to preserve the customer relationship by giving the three Plaintiffs an incentive to continuing purchasing products from CTC. Call this the Customer Incentive payment.

All payments are paid to the law firm representing the Plaintiffs, which disburses the funds at its discretion. CTC believes it is reasonably assured the Plaintiffs, as a group, will earn the maximum $10 million volume incentive payment, since the sales volume required is only a fraction of the Plaintiffs annual purchasing. Further, if the Plaintiffs, as a group, do not achieve the maximum $10 million incentive payment as a result of any action of CTC (e.g., plant closure, inventory shortage), then the full $10 million will be deemed to be earned by the Plaintiffs.

At December 31, 20X2, settlement negotiations are underway with the two of the five Plaintiffs who did not participate in the First Settlement. CTCs legal counsel believes a settlement agreement is probable, and counsel expects the amount of the settlement will be no less than $5 million and no more than $8 million. Call this the Second Settlement.

CTCs fiscal year ends on December 31.

Required:

1. Read Statement of Financial Accounting Concepts No. 6 (CON 6) paragraphs 35-43 and 192-211. As a reminder, CON6 (as well as all other concept statements) can be accessed from the ASC website using the Concepts Statements hyperlink located in bottom left side of the ASC main page. At December 31, 20X2, does CTC have a present obligation to pay the $20 million Overcharge Payment to the Plaintiffs at a specified or determinable date, on occurrence of a specified event, or on demand?

Present obligation

Not a present obligation

2. At December 31, 20X2, does CTC have little or no discretion to avoid paying the $20 million Overcharge Payment to the Plaintiffs?

		Can avoid paying
		Cannot avoid paying.

3. At December 31, 20X2, has the event that obligates CTC to pay the $20 million Overcharge Payment already happened?

		Obligating event has occurred
		Obligating event has not occurred.

4. Based on CON 6, should CTC report the $20 million Overcharge Payment as a liability on its 12/31/20X2 balance sheet?

		Report as liability
		Do not report as liability

5. Briefly explain the logic behind your answer to Question 4.

6. At December 31, 20X2, does CTC have a present obligation to pay the $10 million Customer Incentive Payment to the Plaintiffs at a specified or determinable date, on occurrence of a specified event, or on demand?

		Present obligation
		Not a present obligation

7. At December 31, 20X2, does CTC have little or no discretion to avoid paying the $10 million Customer Incentive Payment to the Plaintiffs?

		Can avoid paying
		Cannot avoid paying.

8. At December 31, 20X2, has the event that obligates CTC to pay the $10 million Customer Incentive Payment already happened?

		Obligating event has occurred
		Obligating event has not occurred.

9. Based on CON 6, should CTC report the $10 million Customer Incentive Payment as a liability on its 12/31/20X2 balance sheet?

		Report as liability
		Do not report as liability

10. Briefly explain the logic behind your answer to Question 10.

11. Read ASC 606-10-32-25 to 606-10-32-27. If the $10 million Customer Incentive Payment is deemed to fall within the scope of ASC 606-10, how will that payment be reported on the income statement?

		As a reduction of revenue
		As in increase in expenses.

12. Read ASC 606-10-32-25 to 606-10-32-27. If the $10 million Customer Incentive Payment is deemed to fall within the scope of ASC 606-10, when will that payment obligation be reported in the financial statements?

		Accrued and reported as a liability on the 12/31/20X2 balance sheet.
		Not accrued at 12/31/20X2. Instead, recognized as the sales to the Plaintiffs occur in 20X3 since such sales are what trigger the payment obligation.

13. Read the scope section of ASC 450-20. At December 31, 20X2, does ASC 450-20 govern the accounting for the Second Settlement?

		Governed by ASC 450-20
		Not governed by ASC 450-20

14. If ASC 450-20 does apply to the Second Settlement, explain what accounting action must be taken in connection with preparation of the December 31, 20X2 financial statements. Be sure to provide relevant ASC cites (to subparagraph level). If you conclude that 450-20 does not apply, just leave the question unanswered.