In November 2011, Wehav Funds, a profitable engineering firm, signed a loan guarantee as a third party for No Certainty Company, a newly formed organization focused on pharmaceutical research and development. Because Wehav Funds was a reputed and successful company, the loan was processed and approved by National Bank at the end of November 2007.
Due to the nature of the pharmaceutical industry, No Certainty projects are considered inherently risky. The company is currently awaiting FDA approval of a miracle drug that, according to marketing research, has the potential to generate millions of dollars of revenue per year. If the drug is not approved, No Certainty will not have the financial resources to continue business. The loan guarantee by Wehav Funds will come into effect, and Wehav Funds will have to front the full amount of the loan.
The end of the fiscal year is approaching, and as the auditor, you must decide how Wehav Funds should account for this loan guarantee in its financial statements.
1. Under what circumstances must a contingent liability be recorded on the balance sheet?
2. When must it be disclosed in the notes?
3. What is the appropriate accounting treatment for the No Certainty transaction with Wehav Funds?
4. Would your “fraud radar” go off if the company refused to record this item in the financial statements?