During the year 2016, the Mason Corporation was named as a defendant in a suit f
ID: 2587515 • Letter: D
Question
During the year 2016, the Mason Corporation was named as a defendant in a suit for damages by the Daley Company for breach of contract. An adverse decision to the Mason Corporation was rendered and the Daley Company was awarded $7,500,000 damages. At the time of the audit, the case was under appeal to a higher court. 1. 2. On December 23, 2016, the Mason Corporation declared a common stock dividend of 6,000 shares with a par value of $2,400,000 of its common stock, payable February 2, 2017, to the common stockholders of record December 30, 2016. The Mason Corporation has guaranteed the payment of interest on the 10-year, first mortgage bonds of the Nunu Company, an affiliate. Outstanding bonds of the Nunu Company amount to $800,000 with interest payable at 4% per annum, due June 1 and December 1 of each year. The bonds were issued by the Nunu Company on December 1, 2014, and all interest payments have been met by that company with the exception of the payment due December 1, 2016. The Mason Corporation states that it will pay the defaulted interest to the bondholders on January 15, 2017 3.
Explanation / Answer
Answer a. A contingent liability is:
a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or
a present obligation that arises from past events but is not recognised because:
b. a reliable estimate of the amount of the obligation cannot be made.
Scenario 1
Answer b: Following audit procedures shall be adopted- Study of contract between Mason Corporation and Daley Company to understand the alleged breach including the quantum of amount. The case should be discussed within the legal department of the company as well as the legal counsels representing the case. The probability of favorable judgement in the higher court should be determined.
Answer c: Where the likelihood of Mason having to pay USD 7.5mn damages is reasonably possible
In this situation, company needs to create provision for the damages as it is unlikely that decision by Higher court will go in favor. The journal entry will be debit to Provision for damages with USD 7.5 million (this will go into the P&L account) and credit to Provision for damages with USD 7.5 million (this will appear in the liabilities).
Scenario 2
Answer b: In the audit procedures, the minutes of the meeting of board of directors as well as shareholders shall be reviewed.
Answer c: No journal entry shall be made for the year ended 31st Dec 2016 as Dividend is accounted during the year in which it is paid. However, the decision to pay dividend on 2nd Feb 2017 shall be disclosed in the notes.
Scenario 3
Answer b: In the audit procedures, records pertaining to guarantee and the terms of issuance of bonds need to be checked.
Answer b: Interest payment for Nunu company Debit USD 16000 and Accrued Interest- Nunu bonds Credit USD 16000. Further an amount of USD 2666.66 (equivalent to 1 month interest for December 2016) should be provided as provision. Interest payment for Nunu company Debit USD 2666.66 and Accrued Interest but not due- Nunu bonds Credit USD 2666.66.
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