Question

CA13-6.  

(Warranties and Loss Contingencies)

The following two independent situations involve loss contingencies.

Part 1: Benson Company sells two products, Grey and Yellow. Each carries a 1-year warranty.

• 1.Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales.
• 2.Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred.

Instructions

How should Benson report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss disclosures that should be made in Benson's financial statements or notes.

Part 2: Constantine Company is being sued for $4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Constantine Company plant in March 2017. The suit was filed in July 2017. Constantine's lawyer states that it is probable that Constantine will lose the suit and be found liable for a judgment costing anywhere from $400,000 to $2,000,000. However, the lawyer states that the most probable judgment is $1,000,000.

Instructions

How should Constantine report the suit in its 2017 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Constantine's financial statements or notes.

Answer 1

PART-1

Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales.

If the contingency is probable and estimable as in this case 1%, it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions.

Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred.

If the contingent liability is probable and inestimable as in this case where chief engineer believes that product warranty costs are likely to be incurred but cannot be reasonably estimated , a note disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable estimate is possible.

PART 2:

The lawyer states that the most probable judgment is $1,000,000.Therefore $1000000 must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition.

If the contingency is probable and estimable, it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions.