Question

Drew is the accounting and finance manager for a manufacturer. At year-end, he must determine how to account for the company's contingencies. His manager, Mary, objects to Drew's proposal to recognize an expense and a liability for warranty service on units of a new product introduced in the fourth quarter. Mary comments, "There is no way we can estimate this warranty cost. We don't owe anyone anything until a product fails and is returned. Let's report an expense if and when we do any warranty work."

Prepare a memorandum for Drew to send to Mary defending his proposal.

Answer 1

Accounting for contingencies

Date: 9th July 2018

To Ms.Mary, Manager, Finance

From: Drew, Accounting and Finance Manager

Re: Your comments on Contingency accounting

_________________________________________________________________________________________

With respect to your coments on to recognize contigent liability of the warranty expenses for our product below are the details of the requirement for contingency accounting.

US GAAP ASC 450-20-25 and as per IFRS IAS 37 deal with the accounting of contingencies and provide the guidelines

Contingencies are described as the events that might happen in future time periods. Contingencies might happen on the occurance of a future event or based on the non occurance of a future event.  

Contigency may be a gain or a loss. Contingent gain would be potential increase in the value of any holding due to occurance or non occurance of any event.  

Rules with respect to discolosure of contingent gains are more strict as compared to contingent losses. Contingent gains are never recorded on the accounts and most are not mentioned in the notes. They are recorded only when there is utmost possibility of occurance and the value can be estimated to the greatest level of accuracy.

Contingent loss would be a potential decrease in the value of the holding due to occurance or non occurance of any future expected event. Contingent liabilities are considered as loss contingencies.

Materiality and full discloure principles are the relevant bases for the accounting of the contingencies.

Below are the different kinds of contingencies and their expected financial treatment:

If the contingent liability is both probable and its value can be estimated then it is recorded as 1) an expense or loss on the income statement, and 2) a liability on the balance sheet. Warranties are the example of such kind of contingent liabilitiy, as there is a probability of its occurance and at the same time the cost can be estmated based on the warranty terms. And accounting treatment for Warranties is that they will be recorded at the time of a product's sale with a debit to Warranty Expense and a credit to Warranty Liability.

A loss contingency which is possible but there is no probability of its occurance or if the accurate amount of the liabilitiy cannot be estimated, then, it will not be recorded in the accounts. Rather, it will be disclosed in the notes to the financial statements.

A loss contingency which has remote chances of occurance will not be recorded and will not have to be disclosed in the notes to the financial statements.

With reference to above, the liability that might arise due to the warranty needs to be accounted for as per the guidelines provide.