Question

Compact Electronics is a leading manufacturer of digital camera equipment. Assume the following transactions occur during the year ended December 31, 2021.

 

Required:

Record any amounts as a result of each of these contingencies.

1. Accounts receivable were $29 million (all credit) at the end of 2021. Although no specific customer accounts have been shown to be uncollectible, the company estimates that 3% of accounts receivable will eventually prove uncollectible.

2. Compact Electronics is the plaintiff in a $5 million lawsuit filed against a supplier. The suit is in final appeal, and attorneys advise it is virtually certain that Compact Electronics will win and be awarded $3.5 million.

3. In November 2021, Compact Electronics became aware of a design flaw in one of its digital camera models. A product recall appears probable and would likely cost the company $600,000.

4. Compact Electronics is the defendant in a patent infringement lawsuit brought by a competitor. It appears reasonably likely Compact Electronics will lose the case, and potential losses are estimated to be in the range of $2.5 to $3.5 million.

Answer 1

Contingent Liability

A contingent liability is a liability of a company that depends on a future event on the basis of a past transaction. It may be called as probable liability or an eventual liability. It may or may not become a liability of a company is entirely depends on future events.

Contingency involves the following:

• Lawsuits

• Income tax disputes

• Discounted notes receivable

• Guarantees of debt

• Failure to follow government regulations

 

Record the amount of the contingencies.

 

1.

 

Prepare journal entry to record the bad debts expense.

 

Accounting equation:

The following is the accounting equation for the bad debts expense:

 

 

      Assets = Liabilities + Stockholders’ Equity

-$870,000 = -$870,000(Bad Debts Expense)

(Allowance for Uncollectible Accounts)

 

Journal entry:

Record the following journal entry in the book of Company CE.

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Bad Debts Expense (E–)		870,000
	Allowance for Uncollectible Accounts (A–)			870,000
	(To record the Allowance for uncollectible accounts to the level of estimated losses.)

 

Explanation:

• Bad debts expense decreases equity by $870,000. Therefore, debit bad debts expense with $870,000.

• Allowance for uncollectible accounts is a contra-asset account and decreases the asset, by $870,000. Therefore, credit Allowance for uncollectible accounts with $870,000.

 

Working note:

Bad debts expense = 3% × $29,000,000

                               = $870,000

 

2.

The company has a contingent gain and it is probable and can be reasonably estimated at 3.5 million. The contingent gains are not recorded until the gain is sure. Hence, the company does not record the journal entry of contingent gain; it discloses the contingent gain amount in the footnotes to the financial statements.

 

3.

The likelihood of a payment occurring is probable, and the amount is reasonably estimated. So, the company records the loss and liability for the estimated amounts of $600,000.

 

Prepare journal entry to record the loss and liability.

Accounting equation:

The following is the accounting equation for the entry:

 

 

Assets = Liabilities + Stockholders’ Equity +$600,000(Estimated Liability) - $600,000(Loss)

 

Journal entry:

Record the following journal entry in the books of Company CE:

Date	Accounts and Explanation	Post Ref	Debit ($)	Credit ($)
		Loss (E–)		600,000
			Estimated liability (L+)		600,000
				(To record contingent liabilities)

Explanation:

• Loss decreases the value of equity. Therefore, debit loss account by $600,000.

• Estimated liability is increased. Therefore, credit estimated liability account by $600,000.

 

4.

The likelihood of a payment occurring is reasonably possible rather than probable. So, the company does not record journal entry of liability. However, the company discloses the range of contingent liability and loss from $2.5 to $3.5 million in the footnotes to the financial statements.

1.

Bad debts expense = 3% × $29,000,000

                               = $870,000

 

2. The company has a contingent gain and it is probable and can be reasonably estimated at 3.5 million. The contingent gains are not

 

3.

The likelihood of a payment occurring is probable, and the amount is reasonably estimated. So, the company records the loss and liability for the estimated amounts of $600,000.

 

4.

The likelihood of a payment occurring is reasonably possible rather than probable. So, the company does not record journal entry of