In May 2002, Checkpoint lost a court case and was required to pay damages of $26 million. Recognizing the $26 million as a liability could violate debt-to-asset and net worth debt covenants. Violation of the covenants could allow a creditor to renegotiate the debt agreement or demand repayment of the debt.

Required:

1. When must U.S. firms record contingent losses and the related balance sheet liability?

2. What does IFRS say about when firms must record contingent provisions?

3. Here is what Checkpoint Systems said about its litigation loss contingency in a note to the

2001 financial statements released on March 28, 2002: The Company is involved in certain legal and regulatory actions, all of which have arisen in the ordinary course of business. . . . Management does not believe that the ultimate resolution of such matters will have a material adverse effect on its consolidated results of operations or financial condition.

The Company is a defendant in a Civil Action No. 99-CV-577, served February 10,1999, in the United States District Court for the Eastern District of Pennsylvania filed by Plaintiff, ID Security Systems Canada Inc. The suit alleges a variety of antitrust claims; claims related to unfair competition, interference with a contract, and related matters. Plaintiff seeks damages of up to $90 million, before trebling, if an antitrust violation were to be determined. This matter is scheduled for a jury trial commencing April 22, 2002. Management is of the opinion that the claims are baseless both in fact and in law, and intends to vigorously defend the suit. If, however, the final outcome of this litigation results in certain of the Plaintiff's claims being upheld, the potential damages could be material to the Company's consolidated results of operations or financial condition.

Based on the information provided in this note, does it appear as though Checkpoint Systems has already recognized a loss contingency related to this lawsuit? Why or why not?

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

5. Explain how recognition of the contingent liability could cause Checkpoint to violate itsnet worth covenant.

6. Is it likely that the banks will just waive the covenant violation if it occurs? (Hint: You may want to review the covenant violation discussion in Chapter 7.)