Question

After expanding Smith Sales Company, Tom Smith asked you to become the controller of the company. Upon accepting the job, you realize that by offering a warranty on several products, Smith Sales Company could significantly raise revenues. Tom understands the benefits of offering warranties, but does not understand the accounting for them.

Requirements: (Part A: 50 points maximum; part B: 50 points maximum)

A. Explain to Tom:

     1. The rational for accounting for contingent liabilities, and

     2. The procedure for estimating and recording warranty expense.

Answer 1

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The rational for accounting for contingent liabilities:
Contingent liability is a potential liability that may occur, depending on the outcome of an uncertain future event. A contingent liability is recorded in the accounting records if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements or not reported at all if both conditions are not met.
Pending lawsuits and product warranties are common examples of contingent liabilities because their outcomes are uncertain. The accounting rules for reporting a contingent liability differ depending on the estimated dollar amount of the liability and the likelihood of the event occurring. The accounting rules ensure that financial statement readers receive sufficient information.
When liabilities are contingent, the company usually is not sure that the liability exists and is uncertain about the amount. FASB Statement No. 5 defines a contingency as “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur”.
According to FASB Statement No. 5, if the liability is probable and the amount can be reasonably estimated, companies should record contingent liabilities in the accounts. However, since most contingent liabilities may not occur and the amount often cannot be reasonably estimated, the accountant usually does not record them in the accounts. Instead, firms typically disclose these contingent liabilities in notes to their financial statements.
Many contingent liabilities arise as the result of lawsuits. In fact, 469 of the 957 companies contacted in the AICPA’s annual survey of accounting practices reported contingent liabilities resulting from litigation.
Recording a Contingent Liability
Assume that a company is facing a lawsuit from a rival firm for patent infringement. The company's legal department thinks that the rival firm has a strong case, and the business estimates a $2 million loss if the firm loses the case. Because the liability is both probable and easy to estimate, the firm posts an accounting entry on the balance sheet to debit (increase) legal expenses for $2 million and to credit (increase) accrued expense for $2 million.
The accrual account permits the firm to immediately post an expense without the need for an immediate cash payment. If the lawsuit results in a loss, a debit is applied to the accrued account (deduction) and cash is credited (reduced) by $2 million.
Examples of Other Accounting Entries
Assume that a lawsuit liability is possible but not probable, and the dollar amount is estimated to be $2 million. Under these circumstances, the company discloses the contingent liability in the footnotes of the financial statements. If the firm determines that the likelihood of the liability occurring is remote, the company does not need to disclose the potential liability.
The procedure for estimating and recording warranty expense:
Warranty expense is the cost that a business expects to or has already incurred for the repair or replacement of goods that it has sold. The total amount of warranty expense is limited by the warranty period that a business typically allows. After the warranty period for a product has expired, a business no longer incurs a warranty liability.
Warranty expense is recognized in the same period as the sales for the products that were sold, if it is probable that an expense will be incurred and the company can estimate the amount of the expense. This is called the matching principle, where all expenses related to a sale are recognized in the same reporting period as the revenue from the sale transaction.
Follow these steps to calculate and record warranty expense:
1. Determine the historical percentage of warranty expense to sales for the same types of goods for which the warranty is currently being determined.
2. Apply the same percentage to the sales for the current accounting period to derive the warranty expense to be accrued. This amount may be adjusted to account for unusual factors related to the goods that were sold, such as initial indications that a recent batch of goods had an unusually high failure rate.
3. Accrue the warranty expense with a debit to the warranty expense account and a credit to the warranty liability account.
4. As actual warranty claims are received, debit the warranty liability account and credit the inventory account for the cost of the replacement parts and products sent to customers.
Thus, the income statement is impacted by the full amount of warranty expense when a sale is recorded, even if there are no warranty claims in that period. As claims appear in later accounting periods, the only subsequent impact is on the balance sheet, as the warranty liability and inventory accounts are both reduced.
It is very unlikely that actual warranty claims will exactly match the historical warranty percentage, so some adjustment of the warranty liability account to actual results will be justified from time to time.
If there is a history of minimal warranty expenditures, there is no need to record a warranty liability in advance of actual warranty expenses. Instead, just record the cost associated with the few warranty claims as they are submitted by customers.