Georgina Sarai Sapién Ramírez 107933036 KIM PARK – LIABILITIES AUSTRAL ELECTRONICS COMPANY First, it is important to define the context of the case. The company issued USD $1 million zero-‐ coupon bonds at 8 years priced to yield 10% interest at maturity date, then a zero-‐coupon bond is defined as a bond that doesn´t pay periodic interest but instead is sold at discount from its face value which in this case is USD $1 million. Then to answer the questions, we need to compute the purchase value of the bond at issue date. It is calculated by dividing the face value of bond (USD $1 million) by the sum of 1 + interest rate (10%) elevated to the time to maturity (8 years), this is a fixed formula: = 1,000,000 = $466,507.38 (1+10%)^8 =1,000,000 = 10% interest =8 years Given this, the zero coupon value at issue date w ould be $466,507.38. Then, for the first question: (1) How should Austral have accounted for the zero-‐coupon bond at the issue date? The company would increase cash and increase bonds payable by the issuance amount of $466,507.38. For the second question, (2) How should the company have accounted for the zero-‐coupon bond at the end of the first year following it issuance? The company will increase interest expense and increase bonds payable by interest at maturity date which is $46,650.74 (10% rate*$466,507.38). Noting that even if the interest isn’t paid they should record it at the moment that the obligation is incurred given the recognition principle. Last, for the third question, (3) At the end of the third year? The company will increase bonds payable and increase interest expense by an amount of $56,447.39 (10% rate*$564,473.93), this last amount is the book value at the end of second year. Following this procedure would lead to the bond’s face value of USD $1 million at the end of 8 years. UNITED AIRLINES, INC. All major airlines have developed frequent flyer programs as a way of increasing passenger loyalty. An airline can account for its mileage liability differently, depending on which set of accounting rules apply to it (FASB/IFRS). From the case we understand that, for United Airlines there are two types of frequent flyer mileage: 1) The miles earned when you take a flight, for frequent flyers. 2) The miles sold to non-‐airline entities for use as awards to customers for using their services such as credit cards. Georgina Sarai Sapién Ramírez 107933036 Today, airlines employ one of two methods to account for both kinds of liabilities for mileage credits: the Deferred or Unearned Revenue Method or the Incremental Cost Method. The Unearned Revenue Method recognizes a liability for the fair value of the outstanding mileage credits. In contrast, the Incremental Cost Method recognizes a liability for the marginal cost of providing air transportation to eligible award passengers meaning the cost to fly one additional passenger on a seat that otherwise would have been empty. So, for the question “How should an airline account for its unredeemed frequent flier mileage obligations?” The method chosen depends entirely on the airlines management decision. Perhaps the most compelling incentive management has to choose the Unearned Revenue Method is the fact that, for any given ticket sale, it allows for significantly higher future revenue recognition opportunities at the point of eventual mileage credit redemption relative to the Incremental Cost Method even though no associated cash inflow exists as a result of mileage credit redemption. Then, the actual amount of frequent flyer tickets is accounted for a decrease in Passenger Revenues account and increase in Unearned Revenues. INTEL CORPORATION To provide some context, in year 1994 a professor discovered a division flaw in his Pentium PC, quickly the report was elevated until it became a broadcast story. Intel offered to replace the fail chips but after some of Intel’s major customers tried to fix the flaw and more tests appointed that the flaw was more common that reported then Intel had to decide quickly on its chip replacement policy and the costs acquired with it. Let’s answer the first two questions as they’re related: (1) Should Intel have recorded a liability for the potential future costs associated with the chip’s flaw? And (2) If so, when should it have recorded the liability? Accounting principles state that a contingent liability should be recognized when the loss is probable (likely to occur) and when the amount can be reasonably estimated. If the probability is reasonably possible or 20%-‐50% possible, then the loss contingency should be disclosed in the footnote. Also, if the amount can be reasonably estimated, this should also be disclosed; if not, the company should disclose that no estimate can reasonably be made. Based on this rule, first we need to determine whether a loss is reasonably possible at any of the stages of the scandal. For example, in early summer of 1994 the possibility of a loss is remote (<%20) so the liability shouldn’t be recorded, by the November 24th date a loss is reasonably possible (%20-‐%50) and should be disclosed in the footnote. For this question, let’s suppose the date December 17th when senior management met to decide. At this point there have been many facts accumulating such as bad publicity from customers, negative test reports, consumer’s claims and decrease on stock prices. Therefore, we can conclude that the loss is highly probable (>50%) and the company will need to record a loss contingency. The company only has a liability to the extent that it has to pay the costs of Georgina Sarai Sapién Ramírez 107933036 producing the chips and the replacement method, also impact on brand equity, potential for lawsuits, expected sales and recall cost if this last can be estimated. Last, the third question is (3) What would have been a reasonable estimate of the liability on December 17th given several of the strategies Intel may have adopted to replace the flawed chips, and given the various possible related claims by customers and other possible costs to Intel? First, we need to determine if we can reasonably estimate the costs under the assumption that Intel will provide a new chip free of charge. There are three important factors to consider in estimating the costs: a) The expected number of chips claimed According to the case, there are 8 million flawed chips produced (6M in products sold and 2M still in inventory). A best case scenario would be, from the 6 million in the market, only 5% of claims made, then one analyst suggested that 25% of customers would respond to the replacement-‐on-‐demand policy and the worst case scenario would be 100% chips returned. Thus, a low to high estimate would be .3 million chips (5%), 1.5 million chips (25%), and 6 million chips, respectively. b) The cost per unit for chips claimed The case states that the average cost per unit, not including labor cost, is between $50-‐$100. Then, the total cost according to the expected number of chips claimed stated above would be: Then, the average cost per unit, including unit and labor cost, is over $400. Then, the total cost according to the expected number of chips claimed would be: c) Any incidental costs (defective inventory, lawsuits, brand equity, expected sales) Additional, there are other potential costs that are not directly determined by the number and cost of chips returned including the following: Ø Defective inventory: Still, there are 2 million defective chips which need to be accounted for. So given the two scenarios presented above and the costs, the total for this chips would be: Georgina Sarai Sapién Ramírez Not including labor/Including labor cost: 107933036 Ø Lawsuits: Until here, it’s hard to estimate the expected costs from lawsuits, the case describes them as “hundreds of millions of dollars in damages”. Ø Brand name: The brand equity built over the years was estimated by advertising industry analysts to be worth $6.4 billion. But actually let’s recall that if brand value is developed internally then it’s not recognized on the balance sheet. Then, even if we could measure the amount of impact, we can’t recognize it as an asset. Ø Future sales: Same as with brand name, as future sales are still not reflected on the financial statements then the impact estimation is irrelevant. Based on preceding calculations, if the costs can be reasonably estimated the costs and the loss is probable (>50%), the company should record the loss and liability on the financial statements. Then, if the method used to implement the repair doesn’t include the labor cost, a loss of at least $20 million should be recorded. If the method used does include labor cost, then a loss of at least $160 million should be recorded. For incidental costs, particularly lawsuits as it is the only concept that can be actually recorded because it is probable but cannot be estimated then it’s likely to only be disclosed in the footnotes.