The exemption of Calico Fashion from paying the loan that was granted by B.G. developers is a capital gain other than a contingent gain because the loan was probable. The loan was probable on the reason that the schedule about its repayment was predetermined thus is reflected on the balance sheet as a liability and for that matter a longterm liability as it was to last for ten years.
The cancellation of the loan payment and specifically the payment of remaining principal mean that the loan account will be debited by the amount equal to the balance at that time in closing the account. This should be followed by crediting the capital account as it is a capital gain. The whole transaction does not affect the income statement because the income statement is meant to reflect the income flows from the trading activities and the cash payments that are meant to settle debts.
The time over which the exemption should be recognised, should be the time at which the offer is expected to commence. This is because the company will be expected to incur expenses of serving the loan for the time being until the time when the offer is valid. Therefore, Calico Fashions should recognize the offer on January 1, 20X3 and not in 20X2.
The amount of money that need to be recognized as capital gain should be equal to $100,000 based on the explanation that the whole sum of principal was to be paid at the end of the lease.
Introduction and Facts
Calico Fashion, Inc. is a retailer for women apparel. The company operates using rented premises and more especially the ones located at the shopping malls. The company opened a new branch in an industrial city where it was meant to rent premises. The urge of opening a new branch in the industrial city came from B. G. developers, Inc., which was as a strategy to revitalize the downtown shopping section of the city. The premises were owned by B.G. developers, where Calico fashion was to come in as a tenant.
The Calico Fashion signed a ten years lease with B.G. developers that was meant to commence on January, 200X1. The lease provided the Calico Fashion several options of termination in various intervals of the lease if Calico did not meet a certain level of sales. Separate from the lease, the B.G. Developers provided loan to Calico Fashions of $100,000 which was meant to enable Calico fashion to do the renovations of the premises as an inducement to enter into the lease.
The loan was given on the condition that the Calico was to repay the loan at a prime interest rate plus a 2% that is due on December 31 annually. The principal amount is payable at the end of the the lease. The new market did not meet the expected sales volume as projected by the B.G. Developers, thus Calico was intending to terminate the lease. Following the intension of Calico terminating the lease, B.G. developers promised to forgive Calico on the repayment of the loan as an incentive for them to stay till the end of the Lease. If they terminate the lease then they were likely to repay according to the original terms of the note. The offer was to be effective on January 1, 20X3.
The Calico management took the offer and decided to stay till the end of the lease term. On the preparation of the income statement the management suggested to report a gain at the end of the year 20X2 at $100,000 resulting from the restructuring of debt. The management suggested the recognition of the gain should be immediately because it was not a contingent gain according to their understanding as they were still to remain a tenant until the end of the lease.
Following the above situation, the main question is to make a justification on whether the forgiven loan is a contingent gain or not and if its not a contingent gain when should it be accounted for as a capital gain. This is addressed in this paper by first looking at the theoretical understanding of a contingent gain and then relating the situation to the authoritative literature that is available in the field of accounting.
The term contingent gain implies the possible gains that a company is likely attain as a result of a successful lawsuit against another company, therefore its a gain that is depended the upon a uncertain outcome. For instance if a company is making a substantial legal claim against another company, then it will have a contingent gain if it attains a successful outcome of the claim. In accounting the contingent gain not accrued (http://findarticles.com/p/articles/mi_hb5582/is_199901/ai_n23546527). Following from the definition of contingent gain, the loan that was written off by B.G Developers is not a contingent gain as the companies were never in involved in any legal issues, otherwise the forgiving of the loan was just an incentive for the Calico to remain the lease.
The attaining of loan into a business is treated as a liability because it implies the external financing of the business activities which are liable for repayment with time. The treatment of loan in the financial books of a company varies depending on the nature of the loan. The loans whose payments are probable are recorded in the balance sheet as a provision and when the loan payments are improbable then its is not recoded in the balance sheet but rather treated as a contingent liability.
The Calico loan is probable implying that it is to be recorded as a liability in the balance sheet. A probable loan implies a loan whose payments are certain in the future like in the case for where Calico was certain on how payments were to be made till the end of lease, thus it qualifies to be recorded in the balance sheet and in this case as a longterm liability.
The payments which are made on servicing the loan are reflected in the income statement like expenses thus they are deducted from the gross income on calculating the net income. For this case, the interest that is paid on loan is expected to be reflected in the income statement as an expenditure. The repayment of the principal amount is also reflected at the time of payment as an expenditure, and this should be followed by debiting the loan account by the same amount, implying a decline in the amount of liabilities of the company (Elliot and Barry 2000).
When a company is exempted from paying its loan, it means that its liabilities have declined. The decline in the liabilities can be perceived as a capital gain in the business because this in money which was invested in the business by an external source who was liable to be refunded but due to the exemption the money is likely to remain in the business and in this case forming part of the business wealth, which is capital. The cancellation of loan repayment follows the step of debiting the loan account by the amount equal to the balance by that time and then credit the capital account by the same amount (Howe. Kimmel and Kieso, 2000). This should be done on the time when exemptions becomes effective.
The loan awarded by B.G. Developers to Calico Fashion is not a contingent liability as its payments are definite. The loan payments are defined for the period of ten years and the exemption of Calico Fashion repaying the loan can not be grouped as a contingent gain because it was out of B.G. Developers strategies that the Calico got an incentive, as Calico had an intention of terminating the lease before the end of the ten years like the other tenants.
The exemption of Calico from repaying the loan as from January 1, 200X3, can be perceived as a capital gain because it has an impact reducing the liabilities without incurring an expenditure on servicing the reduction. In other words, it is like a form of financing a business from an external source on which repayment is not needed thus increasing the asset base.
On a critical evaluation over the action of B.G. developers and from an economic sense, the loan which was offered to Calico by B.G. Developers can be perceived as a business strategy which was meant to sway Calico to stay in business so as to enable the B.G. Developers to attain their goal of retaining Calico as their tenant. After Calico failing to meet the expected sales volume as projected by B.G. developers, it means that Calico was not satisfied with the market condition of the industrial city.
It can be perceived as compensation for the losses that Calico was likely to bear. This does not make the case to qualify as a contingent gain as no party in the transaction who seem to have lost as B.G. developers will still get the benefits of having Calico still occupying the premises as this was the wish for the deal of exempting Calico from the payment of the loan.
Based on the above evaluation and arguments from the authoritative literature, the exemption of Calico Fashions from the repayment of loan should be treated as a capital gain other than a contingent gain. The capital gain should be recognised on the commencement of the offer, that is on January 1, 20X3 other than in 20X2 because the company have to be serving the loan in paying the interest rates until the commencement date of the offer. The capital gain should not be reflected in the income statement because the income statement is meant to show the cash flow during the trading process, thus it should be recorded in the capital account and then reflected in the balance sheet as an increase in the capital base.
Bernstein W., 2006, The Ernest and Young Tax Guide, Perseus Books Group, pp194
Elliot J. and Barry E., 2000, financial Accounting and Reporting , financial Times management, pp 145
Financial Service Industry, 2008, Contingent Gain, Retrieved from: http://findarticles.com/p/articles/mi_hb5582/is_199901/ai_n23546527
Golland J.,2007, International Accounting Standards, Treasury Uk, Retrievd from: http://www.insee.fr/fr/insee-statistique-publique/colloques/acn/pdf11/ppt_en_golland.ppt
Howe H. Kimmel D. and Kieso E., 2000, financial Accounting, Beacon Lumber: Tools for Business decision making, John Wiley and Sons, pp510