Question

CASE STUDY: ASC 450 Contingencies

A tea shop purchases its produce from a vendor without much information about the vendor beside their low prices. Soon the customers started to get sick and it was determined by the CDC that is was salmonella poisoning that was associated with salads that they purchased from this shop. The food poisoning was so severe that some customers experienced kidney and/or liver damage. The vendor went out of business and the tea shop has received undesirable publicity associated with the food poisoning. This has negatively affected revenue and the company is struggling to regain customers. Some customers also have chronic liver and kidney issues and want compensation for their ongoing medical bills. Thus, class action legal proceedings started in March 2019, with a lawsuit against the tea shop seeking $20 million in damages from the company. The shop has a June 30 year-end. The tea shop is self-insured and, thus, the owner is concerned about the lawsuit because the company would be liable for any damages awarded. The tea shop is a private company with bank loans related to their property, plant, and equipment. This company does not issue quarterly financial statements; however, the bank loans require them to have annual audited financial statements. The accounting firm is working on the audit for the June 30 financial statements, which have not yet been issued. As part of the audit procedures, in early August a letter of audit inquiry was sent to tea shop’s legal counsel. On August 15, 2019, the auditors received the legal representation letter from the tea company’s legal counsel. The letter indicates that, owing to developments in the case, it is probable that Tea company will be found liable. The lawyers estimate that the company can expect to pay between $2 million and $3 million in damages and that any number within that range is possible with one number no more likely than another.
You are a new staff person at the accounting firm and have been assigned to this client. Assume today is August 19, 2019. The senior in charge of the audit, Ted Lamoreaux, has given you the accounting research (see Exhibit 1) and resolution (see Exhibit 2) related to this lawsuit and wants you to write an accounting research memo for the 2019 audit file. It is important to address this question quickly as the goal is to issue financial statements by August 31, 2019. [Note: Unless your instructor indicates otherwise, you will not be addressing the disclosure issue—only the accounting for the lawsuit.]
Complete the ‘‘Issues/Questions’’ section of the memo. Write research questions (issues) that are applicable to the case and answerable by the FASB Codification. Make sure to list the research questions in a logical order.

Answer 1

The financial issues presented by the tea shop's legal complications involve the appropriate reporting of contingencies, including probable loss estimation and contingency disclosure in financial statements.

Step-by-step explanation:

The case study involving the tea shop facing a class-action lawsuit in the wake of a salmonella outbreak raises several accounting concerns. Based on ASC 450 Contingencies, the following questions are pivotal to the resolution of this case:

1. How should a company report a contingency that is probable and can be reasonably estimated?
2. What range should be used to estimate the possible loss from a contingency?
3. If no amount within a range of loss estimates is more likely than others, what amount should the entity accrue?
4. When should a subsequent event be recognized in the financial statements?

These questions aim to clarify financial reporting requirements under U.S. GAAP for loss contingencies and guide the preparation of the tea shop's financial statements.