Case 15-2 Burying the Hatchet Mighty Mufflers Corp. (MMC) manufactures exhaust systems

| March 30, 2017

Question

Case 15-2
Burying the Hatchet
Mighty Mufflers Corp. (MMC) manufactures exhaust systems that automakers use in the
production of new vehicles. Competition in this market has waned in recent years. Many
competitors exited the business in the economic downturn and few have returned because
of the capital-intensive nature of the manufacturing process.
In 20X1, the Department of Justice (DOJ) launched an investigation involving MMC and
two additional auto parts suppliers, alleging anticompetitive behavior involving price
collusion between suppliers. Shortly after the DOJ investigation commenced, a number of
customers formed a class-action lawsuit against the three suppliers, alleging that the
suppliers fixed prices and overcharged customers as a result of these anticompetitive
behaviors. Certain entities opted out of the class-action lawsuit and separately undertook
legal action against the individual suppliers, including MMC. These entities are existing
customers of MMC.
In 20X2, MMC reached a settlement (the “First Settlement”) with several of those entities
that opted out of the class action lawsuit (the “Plaintiffs”). The terms of the First
Settlement provide that MMC will pay the Plaintiffs payments of:

$20 million — consisting of $10 million due in 20X3 and $10 million due in 20X4.
$10 million — structured in the form of a volume incentive payment whereby the
Plaintiffs, as a group, will receive a 5 percent rebate on their purchases during
20X3 in an amount not to exceed $10 million.

All payments are paid to the law firm representing the Plaintiffs, which disburses the funds
at its discretion. MMC believes it is reasonably assured the Plaintiffs, as a group, will earn
the maximum $10 million volume incentive payment, since the sales volume required is
only a fraction of the Plaintiffs’ annual purchasing. Further, if the Plaintiffs, as a group, do
not achieve the maximum $10 million incentive payment as a result of any action of MMC
(e.g., plant closure, inventory shortage), then the full $10 million will be deemed to be
earned by the Plaintiffs.
Finally, a separate amount (the “True-Up Payment”) will be payable from MMC to the
Plaintiffs, or vice versa, depending on the settlement (the “Second Settlement”) MMC
reaches with the remaining entities that opted out of the class-action lawsuit but were not
party to the First Settlement. This amount, and whether it is owed by MMC or the
Plaintiffs, will be determined based a formula applied to the Second Settlement amount
and is capped at $5 million.
Required:
1. How much should MMC accrue for the First Settlement as of December 20X2?
2. How should MMC classify the debit resulting from accrual of the First Settlement
in the statement of income?
3. How should MMC account for the True-Up Payment as of December 20X2?
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