To facilitate a sale, Scania guaranteed a customer’s bank loan, which the customer had undertaken to raise funds to finance the payments for Scania’s product. Scania promises that it will make the specified loan payments if the customer defaults. This arrangement is an example of a financial guarantee contract, in which the issuer (Scania) must make payments to the holder of the contract (the bank) for a loss incurred if a specified debtor (the customer) fails to make payments when due. These contracts give rise to accounting liabilities in the form of obligations to stand ready to make payments under circumstances specified in the contract. Both U.S. GAAP and IFRS require initial recognition of the liability at its fair
The warranty in Example 15 illustrates a liability that is of uncertain timing or amount or both. U.S. GAAP refers to these liabilities as loss contingencies, and IFRS refers to them as provisions.18 Recall that the word probablewas also used in the asset and liability definitions, and in that context, it captures the notion of what can be reasonably expected or believed based on the available evidence, acknowledging that the environment of business is inherently uncertain. In contrast, probableas a recognition criterion for liabilities with uncertain amount, uncertain timing, or both, has a different meaning. The IFRS guidance for recognizing these liabilities defines probableas more likely than not, which implies more than 50%. Applying this criterion to Example 15, we can see that Scania would determine whether the likelihood that customers will require warranty services exceeds 50%. U.S. GAAP does not ascribe a precise threshold to probable; we believe that in practice the rule of thumb is approximately 80%. That is, a liability with uncertain amount or timing or both must be at least 80% likely in order for a firm to recognize it. U.S. GAAP and IFRS require similar (but not identical) measurements for these liabilities; both specify that the firm will recognize the liability (that is, measure the liability) at the most likely amount.
The lawsuit (Example 16) illustrates an obligation that a firm would not recognize under either U.S. GAAP or IFRS, although the firm would disclose it in the notes if it judged the lawsuit to be material. The description of Example 16 illustrates the applicability of the recognition criteria for uncertain obligations to a lawsuit. In this example, the firm does not judge the obligation arising from the lawsuit as probable and it cannot reasonably estimate the amount, so the firm does not recognize the potential obligation arising from the lawsuit asan accounting liability. IFRS refers to such items as contingent liabilities. (If the arrangementembodies a possible gain—that is, an asset—the IFRS term is contingent asset). U.S. GAAPdoes not have special terms for these items; descriptively, they are unrecognized loss contingenciesand unrecognized gain contingencies.The financial guarantee contract (Example 17) illustrates an arrangement that containsboth a stand ready obligation and an obligation that is uncertain as to timing and amount.As described in the example, both U.S. GAAP and IFRS require initial recognition of thefair value of the obligation to stand ready to pay the bank if the customer defaults. In addition,both U.S. GAAP and IFRS would require the recognition of a loss contingency (U.S.GAAP) or a provision (IFRS) if the obligation becomes probable and the amount to be paidis reasonably estimable.
Arrangements of the sort illustrated in Examples 15, 16, and 17 are common; for example, most firms that sell products include some kind of warranty (Example 15). Arrangements like the lawsuit in Example 16 are often disclosed, not recognized, because they do not meet the criteria specified for the accounting recognition of obligations as liabilities. For example, Polo Ralph Lauren (whose balance sheet for the year ending March 31, 2007, appears in Exhibit 3.1) displays a commitment and contingencies line on the balance sheet, to direct the user of the financial reports to the notes, specifically, note 15. Scania’s balance sheet (Exhibit 1.5) displays both current and noncurrent provisions, with a reference to note 18. Scania’s provision accounts contain, among other items, its warranty liabilities.
Liability recognition and measurement. The transactions listed below relate to Polo Ralph Lauren (“Polo”). For each, indicate whether the transaction immediately gives rise to a liability and, if so, state the account title and amount that Polo would recognize.
a. Polo’s boutique stores sell gift cards for $100 per card. Assume that gift cards expire 3 years from the date of issuance.
b. Refer to Problem 3.1 for Self Study, part a. Polo receives an invoice for $16 million in advertising services from the supplier, an agency that specializes in television advertisements.
c. Attorneys have notified Polo that the firm is a defendant in a lawsuit claiming $12 million in lost profits and damages, based on allegations that Polo unlawfully used fashion designs belonging to the plaintiff. Polo’s lawyers predict that the court will probably find Polo liable in the lawsuit, and Polo’s management estimates that the range of damages is $2 million to $10 million, with all amounts in this range equally likely.
d. A two week strike by employees closed down one of Polo’s clothing manufacturing facilities. As a result, Polo could not deliver merchandise totaling $20 million, for which it has already received payment.