Mega Company, a public company, is preparing its financial statements for the year ended December 31, 2014. It is now January 31, 2015, and the following situations are being reviewed to determine the appropriate accounting treatment:
1. Mega Company is being sued for $4 million for a possible malfunction of one of its products. In July 2014, a customer suffered a serious injury while operating the product. The company is vigorously defending itself as it is clear the customer was intoxicated when using the product.
2. In a separate lawsuit, Mega is being sued for $3 million by an employee who was injured on the job in February 2014. It is likely that the company will lose this lawsuit, but a reasonable estimate cannot be made of the amount of the expected settlement.
3. Since June 2012, Mega has guaranteed a $1-million bank loan for one of its main suppliers. In September 2014, the supplier started experiencing financial difficulties, which have continued. On December 16, 2014, the bank called Mega Company to confirm that if the supplier is unable repay the loan in January 2015, the bank will be seeking payment from Mega Company under the guarantee.
4. On December 7, 2014, a potential customer injured himself when he slipped on the floor in the foyer of Mega Company's office building. Mega Company did not have appropriate floor mats in place and melting snow from the customer's boots made the floor very dangerous. Mega has negotiated a potential settlement of $200,000 with the individual's lawyer.
Instructions
For each of the above situations, recommend whether Mega Company should (1) make an accrual in its December 31, 2014, financial statements; (2) disclose the situation in the notes to the financial statements; or (3) not report it. Provide a rationale for your recommendations.
TAKING IT FURTHER
What are the potential benefits and costs of making an accrual for a contingency as opposed to only disclosing it in the notes to the financial statements?