Question

The Heinrich Tire Company recalled a tire in its subcompact line in December 2021. Costs associated with the recall were originally thought to approximate $38 million. Now, though, while management feels it is probable the company will incur substantial costs, all discussions indicate that $38 million is an excessive amount. Based on prior recalls in the industry, management has provided the following probability distribution for the potential loss: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) Loss Amount $28 million $18 million $8 million Probability 20% 50% 30% An arrangement with a consortium of distributors requires that all recall costs be settled at the end of 2022. The risk-free rate of interest is 5% Required: 1. & 2. By the traditional approach to measuring loss contingencies, what amount would Heinrich record at the end of 2021 for the loss and contingent liability? For the remainder of this problem, apply the expected cash flow approach of SFAC No. 7 Estimate Heinrich's liability at the end of the 2021 fiscal year. 3. to 5. Prepare the necessary journal entries.

Answer 1

Answer:

1 & 2 )

	Traditional	SFAC No 7
Liability	18,000,000	16,190,460

1. By the traditional approach Heinrich would accrue the more likely than not (more than 50%) amount $18 million

2. Heinrich would record a contingent liability (and loss) of

28,000,000	20%	5,600,000
18,000,000	50%	9,000,000
8,000,000	30%	2,400,000
		17,000,000
PVIF (1 yr, 5%)	0.95238
		16,190,460

4. The difference between $17,000,000 and the initial value of the liability of $16,190,460 represents interest expense which heinrich will accrue during 2019

3 to 5 )

Journal Entries

Event	Particulars	Debit ($)	Credit ($)
1	Loss - Product recall	16,190,460
	Liability - peoduct recall		16,190,460
2	Interest Expense	809,540
	Interest Payable		809,540
3	Liability - product recall	17,000,000
	Loss - Product recall	1,000,000
	Cash		18,000,000