Question 10. The following case applies to questions a-b (i.e., the following three questions).

The following transactions or events are related to Scarlet Industries. Scarlets financial year ends on December 31. The 2016 financial reports were issued on March 15, 2017.

(a) One of Scarlets workers notified management on January 10, 2017 that he planned to sue the company for $1 million related to a work-site injury happening on December 20, 2016. Legal counsel advised that it is probable that Scarlet could lose $200,000 for this lawsuit, but that its extremely unlikely that it could lose $1 million asked for. The outcome of the lawsuit was not known yet on March 15, 2017 when Scarlet issued the 2016 financial reports.

Which of the following statements is appropriate for Scarlet Industries:

1. A loss of $200,000 should be accrued for year 2016.

2. A loss of $1 million should be accrued for year 2016.

3. A loss of $200,000 should be accrued for year 2017 but not for 2016. A disclosure note

   should be provided in the 2016 financial statements.

4. No loss should be accrued for either 2016 or 2017. Only a disclosure note should be

   provided in the 2016 financial statements. Page 3 of 11

(b) In November 2016, state government authorities filed suit against Scarlet Industries, asking civil penalties and injunctive relief for violations of clean water laws. On December 31, 2016, Scarlets lawyers indicated that the likelihood of losing the lawsuit was possible but not probable. On February 3, 2017, Scarlet reached a settlement with state authorities to pay cash $4.2 million in penalties.

Which of the following statements is appropriate for Scarlet Industries:

1. Scarlet should prepare a journal entry to record a loss from litigation $4.2 million and cash payment of $4.2 million for the 2016 financial statements.

2. There is no journal entry for the 2016 financial statements; Scarlet should record a loss from litigation $4.2 million and cash payment of $4.2 million for the 2017 financial statements.

3. Scarlet should prepare a journal entry to record a loss from litigation $4.2 million and the accrued litigation liability of $4.2 million for the 2016 financial statements.

4. Scarlet should record the accrued litigation liability of $4.2 million for the 2016

   financial statements and record the litigation loss and cash payment of $4.2 million for the 2017 financial statements.

(c) Scarlet is the plaintiff in a $45 million lawsuit filed against a customer for costs and lost profits from the contracts signed in October 2016 but rejected by the customer in January 2017. The lawsuit is in final appeal and lawyers advise that it is virtually certain that Scarlet will be awarded $30 million. By March 15, 2017 (i.e., the issuance date of the 2016 financial statements), the final outcome is not known yet.

Which of the following statements is appropriate for Scarlet Industries:

1. Scarlet should prepare a journal entry to accrue a litigation gain of $30 million for 2016.

2. Scarlet should prepare a journal entry to accrue a litigation gain of $45 million for 2016.

3. Scarlet should prepare a journal entry to record a deferred revenue (gain) of $30 million for 2016 and a revenue (gain) of $30 million for 2017 when the final outcome is known.

4. Scarlet should not make any journal entry for this lawsuit for 2016 and should only make a footnote disclosure for 2016.