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rows a ¬xed amount of capital that it commits to repay, with interest, over a ¬xed period.
As shown in Figure 5-1, under accrual accounting these three types of liabilities are
re¬‚ected in the ¬nancial statements when a ¬rm incurs an obligation to another party for
which the amount and timing are measurable with reasonable certainty. Measurement
challenges for liabilities arise when there is ambiguity about whether an obligation has
really been incurred, whether the obligation can be measured, and when there have been
changes in the value of liabilities.


Challenge One: Has an obligation been incurred?
For most liabilities there is little ambiguity about whether the ¬rm has incurred an obli-
gation. For example, when a ¬rm buys supplies on credit, it has incurred an obligation to
the supplier. However, for some transactions it is more dif¬cult to decide whether there is
any such obligation. Consider a situation where a ¬rm assigns the cash ¬‚ows from a note
receivable to a bank, but where the bank has recourse against the ¬rm should the receiv-
able default. Has the ¬rm effectively sold its receivables, or has it really used the receiv-
ables as collateral for a bank loan? If a ¬rm announces a plan to restructure its business

Figure 5-1 Criteria for Recording Liabilities and Implementation
Challenges

First Criterion Second Criterion
An obligation has been The amount and timing of
incurred. the obligation is measurable
with reasonable certainty.




Record a liability.



Challenging Transactions
1. It is uncertain whether the ¬rm has incurred an obligation.
2. The amount and timing of future obligations is dif¬cult to measure.
3. Liability values have changed.
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by laying off employees, has it made a commitment that would justify recording a liabil-
ity? Similarly, has an airline that uses a frequent ¬‚yer program as a marketing device cre-
ated an obligation to provide future travel to its customers? Finally, has a ¬rm that is
subject to a legal suit incurred an obligation? Below we discuss several of these types of
transactions and the challenges they provide for ¬nancial reporting. Although our discus-
sion of these transactions focuses on whether they create future commitments for the ¬rm,
they frequently also raise questions about whether any commitment can be measured.

EXAMPLE: RESTRUCTURING RESERVES. On October 12, 1994, in response to in-
tense competition from the Australian spice producer Burns, Philp & Co., McCormick
& Co. announced plans to lay off 7 percent of its 8,600-person staff, close two spice
plants, and sell off a money-losing onion-ring operation. How should this announcement
be recorded in McCormick™s ¬nancial statements? Had McCormick actually made a
commitment to expend resources to restructure its business? If so, what were the esti-
mated costs of these actions? Alternatively, had McCormick merely announced a plan to
restructure the ¬rm? A plan does not necessarily create an obligation on McCormick™s
part. It can be modi¬ed or abandoned, just as announcements of projected capital outlays
for the coming year can be changed.
The question of whether a restructuring announcement creates an economic liability
from the ¬rm™s standpoint is dif¬cult to resolve. It depends on management™s intentions
when it announces the plan. It is also worth noting that a successful restructuring not
only creates a commitment, but an associated bene¬t in terms of improved subsequent
performance. How are these effects re¬‚ected in ¬rms™ ¬nancial statements?
Current accounting rules on restructuring charges are covered by a number of ac-
counting standards (APB 30 and SFAS 5) as well as SEC rulings. These rules require ¬rms
to create a liability when management has a formal restructuring plan. The liability in-
cludes estimates for costs of eliminating product lines, relocating plants and workers,
new system costs, retraining costs, and severance pay. However, the SEC has argued that
the mere announcement of employee terminations is not suf¬cient grounds for accruing
a liability until speci¬c affected employees have been noti¬ed. It is also interesting to
note that accounting rules do not permit restructuring ¬rms to recognize any future ben-
e¬ts expected from these activities.
These rules leave considerable room for management judgment in reporting for re-
structuring charges. Indeed, as noted in Chapter 7, the SEC has expressed concern that
managers have overstated restructuring charges by making aggressive asset write-downs,
called “taking a bath.” Future performance is then enhanced both by the effect of any
restructuring bene¬ts and by reduced depreciation charges or restructuring credits.
The McCormick restructuring raised concerns among some analysts that the ¬rm had
used write-offs to manage future earnings. In its ¬nancial statements for the fourth quar-
ter of 1994, McCormick created a $70.5 million liability for the costs of the restructur-
ing. However, in February 1995 it reduced the amount of the charge by $3.9 million,
which it added to earnings in the ¬rst quarter of 1995. As a result, it reported a 5.7 per-
cent increase in earnings for the quarter, when earnings would otherwise have declined.
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Analysts criticized McCormick for failing to mention the restructuring credit in its earn-
ings announcement and only disclosing the fact in later reports to the SEC.
Subsequent disclosures on restructuring activities at McCormick further illustrate the
dif¬culties in assessing whether a restructuring announcement is a commitment, and
whether ¬rms have deliberately overestimated the restructuring liability to create a cush-
ion for future years. In 1996 McCormick announced a second restructuring. Most of the
costs of the restructuring ($58.1 million) were recognized as a restructuring liability im-
mediately. However, the ¬rm noted that some charges related to costs of moving equip-
ment and personnel from a closed U.S. packaging plant could not be accrued. These
charges (for $1.9 million) were eventually recognized in the fourth quarter of 1998. In
the third quarter of 1997, McCormick reevaluated its restructuring plans and recorded a
restructuring credit of $9.5 million because plans to sell an overseas food brokerage and
distribution business were not completed. The 1996 restructuring was concluded in the
fourth quarter of 1998, and a further restructuring credit of $3.1 million was reported.

EXAMPLE: FREQUENT FLYER OBLIGATIONS. Many airlines have frequent ¬‚yer
programs for their passengers. These programs are designed to enhance customer loyalty
by offering bonus award miles every time the passenger ¬‚ies with the same airline. Pas-
sengers who accumulate suf¬cient award miles can then redeem them for future ¬‚ights,
hotel accommodations, or rental cars. Since their creation in the early 1980s, airline mile-
age programs have become increasingly popular, prompting some airlines to actually sell
award miles to credit card and phone companies to offer their members as promotions.
The challenge for accounting is to assess whether the airlines have incurred a liability
for the future travel commitments under the mileage programs. There are several reasons
for not viewing the program as creating a commitment. First, the airlines have discretion
to modify or even abandon their mileage programs, should they wish to avoid the com-
mitments. For example, in 1987, United Airlines (UAL) made it more dif¬cult for pas-
sengers to earn free ¬‚ights, at least in part in response to growing concerns about the
potential liability under the program. The changes reduced the number of double and tri-
ple mileage bonuses offered to passengers who ¬‚ew during certain months or on certain
routes. It also required more miles to be earned to qualify for a free ticket to Hawaii, one
of the most popular destinations in the program, and to destinations in Asia and the
South Paci¬c. Finally, the company announced that awards would expire within three
years of the date of issue.
Airlines can also regulate their commitment under frequent ¬‚yer programs by limit-
ing the number of seats available to frequent ¬‚yers. In 1997 the number of outstanding
frequent ¬‚yer miles totaled 3 trillion, compared to only 16.3 billion a decade earlier. Yet
the number of available free seats had not expanded at the same rate. Randy Petersen, of
the trade magazine Inside Flyer, estimated that most airlines made only 7 percent of their
seats available for frequent ¬‚yer awards on a particular route.
In addition to questions on whether an obligation has been incurred, frequent ¬‚yer
programs raise questions about the amount of the obligation. For example, what is the
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cost of frequent ¬‚yer obligations? Given normal load factors and the incremental costs
of an additional passenger, the opportunity and out-of-pocket costs of frequent ¬‚yer
awards could be minimal.
Of course, changing the requirements for mileage awards and making it more dif¬-
cult to collect on awards can be costly”UAL was sued over its plan changes. Further,
the recent sale of mileage awards by airlines reduces the likelihood that there can be sig-
ni¬cant additional reductions in program bene¬ts. As a result of these con¬‚icting views
on the economics of the programs, there are legitimate differences in opinion about the
nature of airlines™ commitments under these programs.
Current accounting rules re¬‚ect the uncertainty about the extent of the commitment.
They provide no de¬nitive guidance on how to report these obligations, potentially pro-
viding an opportunity for management to exercise judgment. In its 1999 annual report,
United Airlines noted that approximately 6.1 million frequent ¬‚yer awards were out-
standing. Based on historical data, the ¬rm estimated that 4.6 million of these awards
would ultimately be redeemed. The ¬rm predicted that the remainder would never be re-
deemed, would be redeemed for nontravel bene¬ts, or would be redeemed on partner
carriers. The ¬rm recorded a liability for $195 million for award redemption, re¬‚ecting
the “additional costs of providing service for what would otherwise be a vacant seat,
such as fuel, meal, personnel and ticketing costs” (see UAL 1999 10-K).

EXAMPLE: LITIGATION. In November 1988, the Public Citizen™s Health Research
Group requested that the U.S. Food and Drug Administration ban silicone gel implants
because a new study by the major manufacturer, Dow Corning Corp., found that the gel
causes a type of cancer in laboratory rats. A number of other experts in the ¬eld, how-
ever, disputed the risks of silicone gel implants, pointing out that the type of cancer
found in the rats has never been observed in women with implants. Dow Corning also
argued that the implants should be allowed to remain on the market. However, the com-
pany subsequently faced a litigation deluge related to the research ¬ndings.
How should these legal claims be re¬‚ected in Dow Corning™s ¬nancial statements?
Should a liability be recognized for potential costs of ¬ghting the claims? Should a lia-
bility be created for the potential cost of any settlement? If so, should the liability be re-
ported on a discounted or undiscounted basis? Or is there no basis for recording any
liability? Dow Corning can certainly argue that any estimate of liability could be viewed
as an admission of guilt and thereby prejudice its case. However, from the perspective
of ¬nancial statement users, the uncertainty surrounding the ¬rm™s legal status is critical
to valuing the ¬rm, and potentially to assessing the performance of its management.
The accounting rules for these types of contingencies are covered in the U.S. by
SFAS 5. Under this standard, a ¬rm is required to accrue a loss if it is probable that a
liability has been incurred and the amount can be reasonably estimated. The standard
argues that if a range of estimates is available, the best estimate within this range should
be reported as a liability. If there is no best estimate, the minimum estimate should be
reported. The FASB recognized that the most dif¬cult issue that arose in reporting con-
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tingencies was for litigation. It resolved that in most cases such events are re¬‚ected only
in the footnotes.
Between 1988 and 1993, Dow Corning provided no liability for the litigation,
although it recognized that monetary damages claimed in the cases might be substantial.
In September 1993, the company announced that it had reached an agreement with
representatives of the plaintiffs and with other defendants for a settlement of up to
$4.75 billion to be paid out over a period of 30 years. As a result, in January 1994, a
charge of $640 million (before tax) was taken for the fourth quarter of 1993. A further
pretax charge of $221 million for the fourth quarter of 1994 was announced in January
1995. These charges included Dow Corning™s best estimate of its potential liability un-
der the agreement and were determined on a present value basis. In the second quarter
of 1995, the company changed the method of accounting for the potential losses from
the present value basis to an undiscounted basis. On May 15, 1995, it voluntarily ¬led
for protection under Chapter 11 of the U.S. Bankruptcy Code.
Given the delicate nature of litigation, management has a strong incentive to under-
estimate potential losses. Indeed, this is likely to also be in shareholders™ best interests.
However, for important litigation cases, such as those for Dow Corning and for cigarette
companies, this implies that investors will have to analyze ¬rms™ effective litigation risks
and costs without much guidance from the ¬rm, leading to potential speculation.


Challenge Two: Can the obligation be measured?
Many liabilities specify the amount and timing of obligations precisely. For example, a
twenty-year $100 million bond issue, with an 8 percent coupon payable semi-annually,
speci¬es that the issuer will pay the holders $100 million in twenty years, and will pay
out interest of $4 million every six months for the duration of the loan.
However, for some liabilities it is dif¬cult to estimate the amount of the obligation.
We saw that this can be an issue for accrued restructuring charges and frequent ¬‚yer pro-
grams. Other examples include environmental liabilities, pension and retirement bene¬t
liabilities, insurance company loss reserves, and warranties. These examples are dis-
cussed below.

EXAMPLE: ENVIRONMENTAL LIABILITIES. In 1980 the Comprehensive Environ-
mental Response, Compensation, and Liability Act (CERCLA) was passed by the U.S.
Congress to clean up inactive hazardous waste sites. The legislation authorized the federal
government to make those responsible for the improper disposal of hazardous waste at the
nation™s worst hazardous waste sites (termed Superfund sites) bear the cost of cleanup. In
addition, polluters must pay to restore damaged or lost natural resources at Superfund
sites. By December 23, 1996, 1,259 current and proposed Superfund sites had been iden-
ti¬ed. Estimates of the cost of cleanups at known sites ranged from $34 to $75 billion.1
There are two challenges in estimating the costs of Superfund cleanups. First, respon-
sibility for the damage and cleanup is uncertain. All parties associated with a site, even
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those that have contributed only a small amount of low-toxicity waste, are liable for the
cost of cleaning it up. Consequently, there are protracted negotiations and legal disputes
over the allocation of costs among these parties. Firms involved in these disputes are re-
luctant to report an estimate of the cost of their share of a Superfund site cleanup, since
to do so could affect their negotiations and legal liability. Second, there is considerable
uncertainty about the actual costs of cleanup, since prior to a detailed study of the site it
is dif¬cult to assess the extent of the damage and the cost of cleanup. Consistent with
this concern, research shows that the explanatory power of models to predict the relation
between cleanup costs and hazard site characteristics is relatively low.2

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